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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2001

Commission file number 1-4373



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THREE-FIVE SYSTEMS, INC.




(Exact Name of Registrant as Specified in Its Charter)


|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 86-0654102                          
|                                                               |  |                                     
|(State or Other Jurisdiction
of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)

|                                         |  |  |  |           
|---------------------------------------- |  |  |  | ----------
|1600 North Desert Drive, Tempe, Arizona  |  |  |  | 85281     
|                                        
|(Address of Principal Executive Offices) |  |  |  | (Zip Code)

(602) 389-8600




(Registrants telephone number, including area code)


Securities registered pursuant to Section 12(b) of the Exchange Act:

|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of Each Class |  | Name of Each Exchange on Which Registered
|                    |  |                                          

|                                       |  |                        
|-------------------------------------- |  | -----------------------
|Common Stock, par value $.01 per share |  | New York Stock Exchange
|                                       |  |                        

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.   Yes  (XBOX)   No  (BOX)

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.  (BOX)

The aggregate market value of Common Stock held by nonaffiliates of the
registrant (18,126,880 shares) based on the closing price of the registrants
Common Stock as reported on the New York Stock Exchange on March 11, 2002, was
$254,863,933. For purposes of this computation, all officers, directors, and
10% beneficial owners of the registrant are deemed to be affiliates. Such
determination should not be deemed to be an admission that such officers,
directors, or 10% beneficial owners are, in fact, affiliates of the registrant.

As of March 11, 2002, there were outstanding 21,510,463 shares of the
registrants Common Stock, par value $.01 per share.

Documents Incorporated by Reference

Portions of the registrants definitive Proxy Statement for the 2002
Annual Meeting of Stockholders are incorporated by reference into Part III of
this Form 10-K.





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TABLE OF CONTENTS



|                                                                                             |                                                                                                  |  |  |  |  |  |  | 
|-------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------ |  |  |  |  |  |  | 
|PART I                                                                                      
|                                                                                             | ITEM 1.    BUSINESS                                                                             
|                                                                                             | ITEM 2.    PROPERTIES                                                                           
|                                                                                             | ITEM 3.    LEGAL PROCEEDINGS                                                                    
|                                                                                             | ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                  
|PART II                                                                                     
|                                                                                             | ITEM 5.    MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                
|                                                                                             | ITEM 6.    SELECTED FINANCIAL DATA                                                              
|                                                                                             | ITEM 7.    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                         
|ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                         
|ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
|PART III                                                                                    
|ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                 
|ITEM 11. EXECUTIVE COMPENSATION                                                             
|ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                     
|ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                     
|PART IV                                                                                     
|ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K                    
|SIGNATURES                                                                                  
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                                  
|EX-23                                                                                       



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THREE-FIVE SYSTEMS, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE YEAR ENDED DECEMBER 31, 2001

TABLE OF CONTENTS

| |  |     
| |  | ----
| |  | Page

PART I

|        |  |                                                     |  |  |    | 
|------- |  | --------------------------------------------------- |  |  | -- | 
|ITEM 1. |  | BUSINESS                                            |  |  | 1  | 
|       
|       
|       
|       
|ITEM 2. |  | PROPERTIES                                          |  |  | 25 | 
|       
|       
|       
|       
|ITEM 3. |  | LEGAL PROCEEDINGS                                   |  |  | 25 | 
|       
|       
|       
|       
|ITEM 4. |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |  |  | 25 | 

PART II

|        |  |                                                                                       |  |  |    | 
|------- |  | ------------------------------------------------------------------------------------- |  |  | -- | 
|ITEM 5. |  | MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS                 |  |  | 26 | 
|       
|       
|       
|       
|ITEM 6. |  | SELECTED FINANCIAL DATA                                                               |  |  | 26 | 
|       
|       
|       
|       
|ITEM 7. |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND
RESULTS OF OPERATIONS |  |  | 27 | 
|       
|       
|       
|       
|ITEM 7A |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |  |  | 35 | 
|       
|       
|       
|       
|ITEM 8. |  | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                           |  |  | 36 | 
|       
|       
|       
|       
|ITEM 9. |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE  |  |  | 36 | 

PART III

|         |  |                                                                |  |  |    | 
|-------- |  | -------------------------------------------------------------- |  |  | -- | 
|ITEM 10. |  | DIRECTORS AND EXECUTIVE OFFICERS                               |  |  | 36 | 
|        
|        
|        
|        
|ITEM 11. |  | EXECUTIVE COMPENSATION                                         |  |  | 36 | 
|        
|        
|        
|        
|ITEM 12. |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT |  |  | 36 | 
|        
|        
|        
|        
|ITEM 13. |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                 |  |  | 36 | 

PART IV

|                                           |  |                                                                                           |     |  |    | 
|------------------------------------------ |  | ----------------------------------------------------------------------------------------- | --- |  | -- | 
|ITEM 14.                                   |  | EXHIBITS, FINANCIAL STATEMENTS AND FINANCIAL
STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K |     |  | 37 | 
|                                          
|                                          
|                                          
|                                          
|SIGNATURES                                 |  |                                                                                           | 38  | 
|                                          
|                                          
|                                          
|                                          
|INDEX TO CONSOLIDATED FINANCIAL STATEMENTS |  |                                                                                           | F-1 | 



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Statement Regarding Forward-Looking Statements

The statements contained in this report on Form 10-K that are not purely
historical are forward-looking statements within the meaning of applicable
securities laws. Forward-looking statements include statements regarding our
expectations, anticipation, intentions, beliefs, or strategies
regarding the future. Forward-looking statements also include statements
regarding revenue, margins, expenses, and earnings analysis for fiscal 2002 and
thereafter; technological innovations; future products or product development;
our product development strategies; potential acquisitions or strategic
alliances; the success of particular product or marketing programs; the amounts
of revenue generated as a result of sales to significant customers; and
liquidity and anticipated cash needs and availability. All forward-looking
statements included in this report are based on information available to us as
of the filing date of this report, and we assume no obligation to update any
such forward-looking statements. Our actual results could differ materially
from the forward-looking statements. Among the factors that could cause actual
results to differ materially are the factors discussed in Item 1, Business -
Special Considerations.





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PART I




ITEM 1.    BUSINESS

Introduction

We design and manufacture display modules for use in the end products of
original equipment manufacturers, or OEMs. We currently specialize in custom
liquid crystal display, or LCD, components and technology. We collaborate
closely with our customers in providing our design and manufacturing services.
Our LCD modules are used in mobile handsets and other wireless communication
devices as well as in the data collection, medical electronics, and other
commercial and consumer marketplaces. We refer to this business as our direct
view display business. In 2001, Motorola was our largest customer. In addition
to our direct view display business, we are pursuing the commercialization of
our liquid crystal on silicon, or LCoS, microdisplays following substantial
research and development over the past several years. We market our services
in North America, Europe, and Asia primarily through a direct technical sales
force.

Industry Overview

Liquid Crystal Displays

Prior to the introduction of LCDs in the 1970s, most commonly used
displays and indicators had substantial limitations as to their use, especially
in terms of size, life, and power consumption. LCDs were developed in response
to these limitations, especially the demand for greater information content and
less power consumption than was possible using light emitting diode, or LED,
technology. LCDs, sometimes called flat panel displays, provide
high-information content displays at competitive prices. LCDs now appear in
products throughout the communications, office automation, industrial, medical,
and commercial electronics industries. LCDs are one of the fastest growing of
the established display industry segments.

An LCD modifies light that passes through or is reflected by it, rather
than emitting light like an LED. An LCD generally consists of a layer of
liquid crystalline material suspended between two glass plates. The liquid
crystals align themselves in a predictable manner when stimulated electrically.
The alignment produces a visual representation of the desired information.
LCDs can display information in black and white or in a wide range of color
combinations. LCD displays consist of a matrix of dots, called pixels, which
are arranged in rows and columns that can be selectively energized to form
letters or pictures. A principal advantage of LCDs over other display
technologies, such as LEDs, is the ability to include thousands or even
millions of pixels in a single display, which allows for greater information
content.

There are two types of LCDs: active matrix and passive matrix. Active
matrix LCD displays are relatively complex devices that require manufacturing
operations involving very large capital investments. Historically, active
matrix LCD displays have been used in larger, high-information content
applications, such as laptop computers, but they are beginning to appear in
mobile devices, such as cellular handsets and PDAs. Passive matrix LCD
displays are less complex and less expensive to manufacture. Currently,
passive matrix LCDs are the primary display used in applications such as mobile
handsets and PDAs, as well as in office equipment, data collection terminals,
point-of-sale equipment, medical devices, transportation instrumentation, and
industrial instruments and controls.

The Custom Mobile LCD Market

We estimate that the worldwide market that we service for custom passive
and small form factor (ten-inch or less diagonal) active matrix LCD modules was
approximately $6.6 billion in 2001. This market includes displays used in
mobile handsets and other communications equipment; business, industrial and
transportation equipment; and computer and consumer products. According to
industry resources, the worldwide market for LCDs in mobile handsets was
slightly under 400 million units in 2001.

The increasing complexity and functionality of handheld products, such as
wireless computing and communication devices, require OEMs to increase the
visual performance and information content of the displays incorporated into
their products. At the same time, the market continues to demand that OEMs
incorporate displays with reduced power requirements and lower costs. Custom
passive LCDs, including both monochrome and color

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displays, address these requirements for high performance, increased
information content, low power, and low cost. In addition, active matrix
displays are rapidly making advances in cost reduction and power consumption
and are beginning to be used in mobile applications.

OEMs also seek ways to differentiate their products from the products of
their competitors. Custom-designed display modules provide OEMs a
cost-effective means to achieve this differentiation. In designing its
product, an OEM must determine whether to use standard off-the-shelf display
modules, to design its own custom display modules for production by a custom
display manufacturer, or to enter into arrangements with a third party for
custom display design and production. In making a decision to engage third
parties for custom design and production, OEMs recognize that standard
off-the-shelf displays make it more difficult to differentiate their products
from those of their competitors. In considering whether to design their own
display modules, OEMs often recognize that their greatest strengths consist of
consumer brand name recognition, market research and product development
expertise, and highly developed sales and distribution channels. Advanced
design and manufacturing processes require increasing investments for research
and development, personnel, and equipment. Competitive market conditions
require a shorter period of time from product conception to delivery, product
differentiation, improved product user friendliness, and continually enhanced
product performance and reduced product cost during the life cycle of the
product. As a result of these factors and increasingly sophisticated and
complex technology, it has become more difficult for even the leading OEMs to
maintain the necessary technology, expertise, personnel, and equipment to
design and produce internally all of the various components necessary for their
products. As a result, there has been a trend toward outsourcing the design
and production of components such as display modules.

In addition to design and production, OEMs have increased their use of
third-party suppliers to add additional components to their products. This
permits the integration of more of the manufacturing steps into fewer
locations. This trend toward integration and outsourcing decreases the number
of suppliers necessary to produce a final product and results in lower costs.

The Emerging Microdisplay Market

Market trends demand high-information, power-efficient displays with
increasing functionality and smaller sizes at relatively low costs.
Microdisplays based on liquid crystal on silicon technology provide a response
to those demands.

Liquid crystal on silicon microdisplays are a form of active matrix LCD in
which liquid crystalline material is suspended between a glass plate and a
silicon backplane rather than between two glass plates. The silicon backplane,
which is essentially an integrated circuit, provides drive signals for each
pixel element of the display as well as logic functions, such as serial to
parallel conversion and data storage. Because CMOS silicon integrated
circuits, which is a highly developed technology, form the basis of these
displays, liquid crystal on silicon technology permits a very high-information,
high-performance display in a small size and at a relatively low cost.

Microdisplays are no larger than a thumbnail, but contain all of the
information appearing on a high-resolution personal computer screen. The tiny
image on a microdisplay can be projected onto a screen or other surface for
individual or group viewing or used in a portable application that is viewed
through a magnifying device similar to a viewfinder. Various types of
projector applications represent the most common current use of microdisplays.
Projectors can cast the information on a distant large screen, as in
audio-visual front projectors, or shine the image through a translucent screen,
as in rear projectors. Potential initial microdisplay applications include use
in large-screen televisions, business projection equipment, and computer
monitors. Other potential applications include a wide variety of portable
devices, such as wireless Internet access devices, mobile handsets, pagers, and
PDAs as well as wearable computing equipment using head-mounted displays, which
allow hands-free access to large amounts of information.

A well-developed front projector market currently exists. These products
are typically referred to as audio-visual projectors and are generally fixed or
portable products used in business applications. Most front projectors
currently use microdisplays that are either transmissive polysilicon or digital
micro-mirror devices, also called DMDs. We believe, however, that reflective
liquid crystal on silicon technology will provide more information at a lower
cost.

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Emerging market segments are beginning to develop for large,
cost-effective, higher-resolution television screens and monitors. Current
display technologies for digital and high-definition televisions and computer
monitors encounter serious barriers related to cost, resolution, and dimensions
when used for high-resolution large screens. Many companies have begun
incorporating microdisplays into large, high-resolution screens to enable
affordable display solutions. As in the front projection marketplace, we
believe that LCoSmicrodisplays can provide more information at a lower cost as
compared with transmissive polysilicon or DMDs.

Significant development efforts are currently being directed to portable
microdisplays as a potential method for delivering high-information content at
low cost and with low power consumption in mobile, hand-held communication
devices. It is widely assumed that converged voice and data communication
devices have the potential to become a new class of products in mobile
communications, potentially integrated with PDA functions, such as phonebooks
and calendars. Delivery of high-information content over a small, direct-view
display in a handheld device, however, presents difficult technological
challenges. Portable microdisplays used with a viewfinder offer a potential
solution because they can deliver as much information as a computer monitor in
a very small, lightweight, and power-efficient package.

The portable microdisplay market is just beginning to develop. Market
potential currently is uncertain and is limited by such factors as the
availability of sufficient wireless communication bandwidth, the uncertainty of
customer acceptance, and the possibility of alternative technologies.
Nevertheless, many companies have prototype programs underway to develop new
converged mobile communication products with large information content at low
cost, and many of these companies are assessing the use of LCoSmicrodisplays
for use in these products.

The Three-Five Approach

We seek to provide our customers with high-performance, information-rich,
low-power consumption displays that have competitive advantages in terms of
size, cost, and product differentiation. To accomplish this goal, our research
and development activities focus on technological developments intended to meet
the current and future requirements of our customers. We add value for our
customers through our ability to integrate the design and production process,
which reduces the time between product conception and market introduction. Our
emphasis on customization and technological leadership has positioned us to
develop new custom product solutions for our customers as they seek displays
with more information content at lower cost.

Our custom product solutions provide OEMs with the following benefits:



| |  |  | access to specialized design and manufacturing technology and expertise;                                                                      
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | accelerated design process and reduced design and
manufacturing costs through the use of our specialized personnel,
equipment, and facilities;
|
| |  |  | reduced reliance on multiple suppliers for components and
integration of their production processes; and                                      
|
| |  |  | the ability to concentrate their own resources on the design,
production, and distribution of their core products.                            

By eliminating the duplication and overlap of investment and resources, we
and our OEM customers are able to work together more economically. We
concentrate on the development of our display technologies and their
applications to products, while our customers devote time and resources on
market development for these products.

Our historical target market consists of high-end monochrome passive
matrix LCD modules of 1/4 VGA (320 x 240 pixels) or less resolution,
primarily those having smaller than ten-inch diagonal screen sizes. We do not
address low-end LCD display markets, such as watches and calculators. In 2001,
we added color passive and active matrix LCD technologies for small display
product applications. Our target market for LCoSmicrodisplays consists of
displays of SVGA (800 x 600 pixels) or higher resolution.

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Direct View Display Strategy

Our strategy in our direct view display business is to enhance our
position as a leading worldwide supplier of custom-designed and manufactured
displays for application in various high-growth segments of the electronics
industry. Key elements of our strategy include the following:

Target Leading Customers in High-Growth Industries

We identify industries that we believe have the greatest long-term
potential for growth. We recognize that our growth and development is closely
aligned with the growth and development of the industries we serve. Current
targeted industries include mobile handsets and other wireless communication,
data collection, office automation, medical equipment, and other commercial and
consumer marketplace products.

Within each industry, we target leading companies that we believe would
benefit from our design and manufacturing services. Targeted customers
typically are Fortune 1000 manufacturing companies whose products require
display devices. Our sales and engineering staffs then attempt to demonstrate
the benefits that the potential customer would derive by outsourcing to us the
design and production of display devices required in their products. Recently,
we have refocused our efforts on high-end products where our advanced
technologies, design expertise and response time provide an advantage over more
commodity-oriented LCD vendors.

Once we establish a relationship with a new customer, we endeavor to
develop new programs for other product groups within the customers business.
For this reason, we specifically target customers with multiple divisions or
product lines.

Expand Customer Base

We intend to continue our efforts to expand our customer base. We also
plan to target specialized markets that have both volume requirements and
require a more complex display solution. We will continue to seek
opportunities in growing and emerging markets, both in the United States and
internationally.

Establish Close Relationships with Customers

We seek to establish strong and long-lasting customer relationships
through our fundamental business practice, which we refer to as customer
partnering. Customer partnering involves aligning our prospects with those of
our customers and seeking to make our engineering and production staffs
seamless extensions of the product design and production departments of our
customers. This includes our engineers spending a significant portion of their
time assisting customers with their own engineering efforts at their
facilities. In addition, our customers engineers sometimes spend time in our
facilities.

We stress product solutions for our customers products. We view each
customers new product as our own and take pride in creating and implementing
innovative engineering solutions that differentiate the customers product from
competitive products. In connection with this philosophy, we have positioned
ourselves to provide a rapid response to our customers and their worldwide
operations.

To achieve our customer partnering goal, we emphasize corporate cultures,
customs, and communications that complement those of our customers. A thorough
understanding of our customers products and business goals enables us to
anticipate customer needs and to develop new design and production solutions
for their products.

We continually attempt to enhance the competitive position of our
customers by providing them with innovative, distinctive, and high-quality
display devices on a timely and cost-effective basis. To do so, we work
continually to improve our productivity, lower our costs, and speed the
delivery of our product solutions. We endeavor to streamline the entire design
through delivery process by maintaining an ongoing engineering and
manufacturing improvement effort.

We continue to provide customer support after product design has been
completed and production has been commenced. Through such follow-on activity,
we conduct quality enhancement and cost-reduction efforts to maintain the
competitiveness of our customers products.

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Provide Advanced Custom Design and Manufacturing Services

We seek to design, prototype, and manufacture, on a timely and
cost-effective basis, a wide range of innovative, distinctive, and high-quality
display devices for operational control and information display functions
required in the end products of OEMs. Our design processes utilize advanced
computer-aided design software to provide custom solutions for customers
products in time frames and on cost bases that we believe are substantially
shorter and lower-priced than industry norms.

Until the end of the third quarter of 2001, we operated our highly
automated, high-volume LCD manufacturing line in Arizona to produce the
majority of our LCDs. In order to enhance cost-effectiveness and take
advantage of lower cost manufacturing environments, we made the decision in
2001 to move the LCD line to Asia. We expect that the high-volume LCD line
will resume production in Asia later in 2002. Until that time, we are
outsourcing all of our LCD glass fabrication. In addition, we have entered
into relationships with manufacturers of color LCDs. Under these
relationships, we will custom design the color LCD screens for our customers
unique applications and then outsource the manufacture of these screens.

Regardless of whether we manufacture or outsource LCD screens, we perform
all back-end and module manufacturing for our products. We utilize advanced,
flexible manufacturing systems for high-volume module assembly in Manila and
Beijing. We believe our manufacturing facilities provide us with a competitive
advantage in meeting the custom LCD needs of our customers. We anticipate that
our ability to design, prototype, and manufacture customized product solutions
will be enhanced by the expansion of our engineering personnel, our increased
design capacity, and our ability to meet our LCD requirements. We will continue
to explore the most advanced and cost-efficient production methods for each
product solution.

Exceed Customer Requirements Through Speed and Efficiency

We emphasize innovative design and manufacturing techniques to improve the
speed, efficiency, and performance of our design and manufacturing services.
This enables our customers to address the pressure to reduce the lead times for
market introduction of their products. As part of our development process, we
continually improve and modify our design and manufacturing processes,
controls, and methodology in an effort to support our customers requirements.

Leverage Research, Development, and Engineering

We continually strive to develop and acquire new technologies and utilize
technological developments in order to provide practical solutions for our
customers. We conduct an active research and development program designed to:



| |  |  | continually improve our products and create new products;                               
| | - |  | ----------------------------------------------------------------------------------------
|
| |  |  | increase our efficiency;                                                                
|
| |  |  | reduce our costs;                                                                       
|
| |  |  | improve the speed, efficiency, and performance of our design and manufacturing services;
|
| |  |  | develop new design and manufacturing processes and techniques; and                      
|
| |  |  | enhance the quality, cost-effectiveness, and value of our services.                     

We plan to expand our research and development efforts through increased
expenditures and the hiring of additional personnel to meet the expectations of
our customers and to satisfy our goal to design and produce the most advanced
product solutions on a timely and cost-effective basis. In addition, we are
continuing the development and expansion of existing LCD technologies as well
as new technologies, such as polymer light emitting displays. In 2001, we
formed a company with DuPont Displays to develop and commercialize OLED
technology. Under that arrangement, we will supply design, engineering and
module manufacturing services and DuPont Displays will supply OLED screens and
development services.

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LCoSMicrodisplay Strategy

Our strategy in LCoSmicrodisplays is to become a leading worldwide
supplier of microdisplays for use in both projection and mobile applications.
Key elements of our strategy include the following:

Develop Leading Customers in Targeted Industries

We identify industries that we believe have the greatest potential for
using microdisplays, both immediately and in the future, and we focus on the
leading companies in those industries. We believe that the use of our
microdisplays by leading companies will encourage other companies to adopt this
new technology. Current targeted industries include large screen televisions,
AV projectors, monitors, mobile handsets, and other mobile wireless
communication, medical equipment, and other commercial and consumer marketplace
products.

Establish Close Relationships with Customers; Provide Advanced Products and Manufacturing Services

As in our direct view display business, we seek to establish strong and
long-lasting customer relationships through customer partnering. This
involves aligning our prospects with those of our customers and seeking to make
our engineering and production staffs seamless extensions of the product design
and production departments of our customers.

Unlike our direct view display business, however, we are focusing on
standard products in microdisplays. We seek to work closely with our customers
and potential customers to understand their display needs and then design
products that attempt to meet those needs, both from a technological and cost
point of view.

We utilize an advanced manufacturing line in our Tempe facility to
manufacture and test LCoSmicrodisplay imagers. We continue to increase our
production personnel and add sophisticated manufacturing equipment to meet
expanding capacity requirements. We will continue to explore the most advanced
and cost-efficient production methods for each product solution. As part of our
development process, we continually improve and modify our design and
manufacturing processes, specifications, controls, and methodology in an effort
to support our customers requirements.

Continue Research, Development, and Engineering

We consider microdisplays a new product category that is in the process of
starting high-volume manufacturing, but which requires substantial, additional
development work. Therefore, we will continue our active research and
development program designed to:



| |  |  | continually improve our microdisplay products and create new products;   
| | - |  | -------------------------------------------------------------------------
|
| |  |  | increase our yields;                                                     
|
| |  |  | reduce our costs;                                                        
|
| |  |  | develop new design, test, and manufacturing processes and techniques; and
|
| |  |  | enhance the quality, cost-effectiveness, and value of our services.      

We plan to continue our substantial focus on research and development
efforts and we may even increase expenditures and hire additional personnel to
meet the expectations of our customers and to satisfy our goal of designing and
producing the most advanced product solutions on a timely and cost-effective
basis. We recently acquired the intellectual property of Zight Corporation.
As a result, we will also expand our efforts to enhance the products initially
developed by Zight.

Products and Services

We currently engage in the design and manufacture of direct view display
modules, microdisplay imagers, and the development and commercialization of
manufacturing technologies for use in various products of OEMs.

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Direct View Display Business

Most of our revenue currently results from the sale of custom designed LCD
display modules. A manufacturer of a complete system or product requiring a
specific type of visual display, such as a mobile handset, medical instrument,
business machine, or hand-held data collection device, represents a typical
buyer for a custom LCD display module. For each custom display module, we work
directly with our customer to develop and produce the original design and to
manufacture the display module in accordance with the customers
specifications. At a minimum, each module includes an LCD, a custom LCD
driver, and a flexible connector. We also provide value-added services by
assembling additional components onto the module, such as keypads, microphones,
speakers, light guides, and optics. In 2001, LCD custom display modules
accounted for approximately 95% of our net sales.

We have developed a sophisticated design process to meet the specific
needs of our customers applications. Each design project normally involves a
cross-functional team of our engineers who are assigned to a customer program.
The team consults with the customers engineers throughout the design,
prototype development, and manufacturing process. We continue to supply
value-added engineering support after the design solution has been developed
and integrated into the manufacturing process in an ongoing effort to provide
customers with product performance enhancements and cost-reduction
opportunities.

The difficulties in developing a custom LCD module include frequently
changing customer expectations, evolving customer requirements, and changing
customer end-product specifications. These factors result in lengthy lead
times for market introduction of customers products. To overcome the
traditional obstacles involved in custom design and development, we have
developed the four-phase program development process described below. We
combine our program development process with our philosophy of being a
seamless extension of our customer. This results in a very flexible,
responsive, accurate, and fast development cycle that enables our customers to
introduce their products into the market rapidly. Our program development
process consists of the following phases:



| |  |  | Feasibility and concept phase.We work closely with our
customer to understand its requirements. Customer input varies from
rough sketches to detailed specifications. Experienced LCD module
design engineers work to develop conceptual solutions to customer
requirements that include both design and cost parameters.      
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Prototype phase. We conduct a design review with the
customer; complete a proposed design, including the electrical,
mechanical, and optical features of the LCD display module; and
deliver a prototype to the customer.                                                                                                      
|
| |  |  | Pilot phase. We perform a thorough design review with our
customer, involving an analysis of performance, cost, and volume
production considerations. A successful pilot phase results in the
completion of any design changes, the ordering of the tooling
required for production, and the delivery of manufacturing samples.
|
| |  |  | High-volume production phase. We complete any required
changes in the manufacturing process, receive necessary tooling, and
commence high-volume production. All high-volume module production
takes place either in Manila or Beijing.                                                                                        

LCoS Microdisplay Business

The display market demands continually greater information content at
reduced prices. In response to these demands, we are pursuing the
commercialization of LCoSmicrodisplays following several years of extensive
research and development activities. Our LCoStechnology provides very high
information content in a small size and at an expected relatively low cost.
The information presented by these displays is magnified for view, generally
either by a projector or by a viewfinder. We believe that the inherent
capability of our LCoStechnology provides a cost-effective solution to
increased information demands.

We are developing a broad range of LCoSmicrodisplay products to offer
customers. The table below sets forth various resolutions with approximate
pixel count, or the number of color dots on a screen, and potential uses for
our LCoSmicrodisplays. We currently have multiple LCoSapplications, which we
have prototyped for customer evaluation. We are focussing on products with the
capability to produce all of the following resolutions:

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|           |  |             |           |              |  |                                                                                                    
|---------- |  | ----------- | --------- | ------------ |  | ---------------------------------------------------------------------------------------------------
|Resolution |  | Pixel Count |           | Applications
|           |  |             |           |             
|SVGA       |  |             | 480,000   |              |  | Hand-held devices, such as PDAs or mobile handsets, and
head-mounted displays or wearable computers
|          
|          
|          
|          
|XGA        |  |             | 780,000   |              |  | Low-end portable audio-visual projectors                                                           
|          
|          
|          
|          
|SXGA       |  |             | 1,300,000 |              |  | High-end portable audio-visual projectors, rear-projection
monitors, and high-definition television
|          
|          
|          
|          
|HDTV 1     |  |             | 922,000   |              |  | High-definition digital televisions and imaging applications                                       
|          
|          
|          
|          
|HDTV 2     |  |             | 2,000,000 |              |  | High-definition digital televisions and imaging applications                                       

We believe that the initial markets for our LCoSmicrodisplay products
will be in front projectors, large screen television sets and computer
monitors, and near-to-the-eye applications, such as wearable displays.
Currently, the front projector, and digital and large screen television markets
are being served by active matrix polysilicon microdisplays and DMD
microdisplays. Polysilicon microdisplays are manufactured by two large
Japanese companies. At resolutions above XGA, these products generally need
special optics and are generally larger and more expensive than anticipated
costs for LCoSmicrodisplays. DMD microdisplays are a proprietary product of
Texas Instruments. DMDs are relatively expensive to manufacture, especially
for larger devices with higher resolutions, and involve a high cost of capital.
The expected relatively low cost for LCoSmicrodisplays makes them more
suitable for competitive consumer marketplaces.

We believe another market for LCoSmicrodisplay products will be in
personal display system applications, such as converged wireless products
requiring high-information content displays for e-mail and access to the
Internet. Use of an LCoSmicrodisplay in a personal display system application
would enable a person to carry a portable device capable of delivering
information at the same SVGA resolution as the persons desktop or laptop
computer. This has the potential to allow portable access to the Internet and
critical information, such as calendars, maps, e-mail, and documentation, in a
handheld product. The high resolution of the device would avoid scrolling or
time-consuming text conversions in accessing the Internet for needed
information. Other potential viewfinder applications would be in entertainment
and medical devices.

We plan to offer a range of LCoSproduct solutions with different levels
of integration from individual imagers to fully integrated display systems. In
addition, we have been working with optical companies that are interested in
developing optical light engines for sale to OEMs that manufacture monitors and
televisions. A light engine consists of a projection lens, color management
system, illumination systems, including a lamp, and the microdisplays. LCoS
microdisplays require different optics than those employed when using
transmissive polysilicon microdisplays.

We have undertaken extensive development efforts in LCoSproducts, and we
expect to incur substantial losses in the microdisplay business until volume
production of LCoSmicrodisplays occurs. We initially expected volume
production of LCoSmicrodisplays to commence in 2001. High-volume production
was delayed, however, due to manufacturing and yield issues in our
manufacturing line as well as product delays by our customers.

Sales and Marketing

We approach sales and marketing on three levels: engineer to engineer,
salesperson to procurement, and factory to factory. Our approach is to treat
an existing program as a marketing platform for the next program. Our
engineering, marketing, and sales groups provide ongoing services to our
customers throughout the life of product programs. These services include
implementing continuous improvement tools related to both the products cost
and technical performance. This service function allows us to market future
sales within our customer base.

We market our services primarily in North America, Asia, and Europe
through a direct technical sales force resident in those areas. A staff of
in-house, Arizona-based engineering personnel directs and aids all sales
personnel.

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Our sales to customers in North America represented approximately 15.8% of
net sales in 2000 and 16.8% of net sales in 2001. Our sales to customers in
China represented approximately 38.5% of net sales in 2000 and 40.6% of net
sales in 2001. Our sales to customers in other foreign countries represented
approximately 45.7% of net sales in 2000 and 42.6% of net sales in 2001.

We have a representative relationship with Mitsui Co., Ltd. of Tokyo,
Japan. Under this relationship, Mitsui markets and sells LCoSmicrodisplay
products in Japan.

Customers

Our strategy in our direct view display business involves concentrating
our efforts on providing design and production services to leading companies in
mobile handsets and other wireless communication, data collection, office
automation, medical equipment, and other commercial and consumer marketplaces.
As a result, we derive our net sales from services provided to a limited number
of customers.

Our largest customer is Motorola. Sales to Motorola, including their
subcontractors, accounted for approximately 85.4% of our net sales in 2001 and
86.9% of our net sales in 2000. No customer other than Motorola accounted for
more than 10.0% of our net sales in 2000 or 2001. Substantially all of the net
sales for Motorola programs in 2001 were for mobile handset applications. In
2001, however, we received no design wins at Motorola for mobile handset
applications. Instead, our design wins with Motorola were in other
applications, such as telematics, which is cellular applications in
automobiles. Motorola has an LCD module allocation process in which it
communicates to each vendor the anticipated annual range of purchases. Under
that program, it provided an indication that purchases by Motorola from us
during 2002 would be substantially less than 2001 levels. See Item 1 Business
 Special Considerations  Motorola accounts for a significant portion of our
sales.

Backlog

As of December 31, 2001, we had a backlog of orders of approximately $18.7
million. The backlog of orders as of December 31, 2000 was approximately $63.8
million. Our backlog consists of product orders for which confirmed purchase
orders have been received and which are scheduled for shipment within 12
months. The lead time for orders was substantially reduced during 2001; in
fact, most orders are now given with only a six to eight week lead time. Most
orders are subject to rescheduling or cancellation by the customer with limited
penalties. Because of the possibility of customer changes in delivery
schedules or cancellations and potential delays in product shipments, our
backlog as of a particular date may not be indicative of net sales for any
succeeding period.

Manufacturing Services, Facilities, and Quality Control

Manufacturing Services

We have organized our manufacturing geographically to optimize the
combination of technology and labor factors. This organization enables us to
compete solely on the basis of cost, if necessary, with suppliers of similar
products and services throughout the world to the extent we determine to do so
based on profitability levels. Our advanced manufacturing techniques include
surface mount technologies, chip-on-board, chip-on-flex, chip-on-glass,
flip-chip, tape automated bonding, and sophisticated testing systems throughout
these processes.

We seek to increase our value to our customers by providing responsive,
flexible, total manufacturing services. To date, our manufacturing services
have been concentrated on the manufacture of LCDs and assembly of display
modules that we have designed. We provide extended manufacturing services
beyond these core services, however, if the customer requires them. Extended
services may include adding additional components, such as keypads,
microphones, speakers, light guides, and optics, or the turnkey manufacture of
a complete assembly.

Manufacturing Facilities

We currently conduct manufacturing operations in Tempe, Arizona; Manila,
the Philippines; and Beijing, China.

Our dedicated LCoSmicrodisplay production line is at our Arizona
facility. The facility consists of 16,000 square feet of Class 100, 1000 and
10,000 clean room areas where wafer scale LCoSprocessing, core assembly,

9



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packaging, and automated testing is preformed. We are also completing
construction of new clean rooms so that we can perform all manufacturing,
packaging, and module assembly for LCoSproducts at our Arizona facility.
Facility personnel include a team of experts ranging from research scientists
to specialized engineers with backgrounds in electronics, mechanics, chemistry,
physics, and manufacturing. We maintain a wide variety of state-of-the-art
testing and quality control equipment at the facility.

The Arizona facility previously housed a fully automated LCD production
facility. We utilized this facility to manufacture high-volume LCD glass
panels and to conduct LCD research and development, to produce prototype and
pre-production runs of devices for customer approval, to conduct full
production runs of low-volume devices, and to develop advanced manufacturing
processes that could be applied in Manila and Beijing during full-scale
production.

We made the decision in 2001, however, to move the LCD line, as well as
all prototyping activities, to Asia to take advantage of its lower cost
manufacturing environment. All prototyping activities are now conducted in
Manila and Beijing. We expect that the high-volume LCD line will resume
production in Asia later in 2002.

We conduct high-volume LCD module manufacturing in Manila and Beijing. In
January 2001, we moved from our old location in Manila into a custom-designed,
built-to-suit manufacturing facility in the Carmelray Industrial Park near
Manila in the Philippines. The term of this lease for the factory in Manila is
125 months. This new 65,000 square foot manufacturing and design facility
incorporates state-of-the-art manufacturing equipment and a class 10,000
cleanroom environment. This new facility is focused on module manufacturing
and is staffed entirely with direct labor employed by us. In addition, the new
manufacturing facility has been outfitted with specific tooling and equipment
unique to our manufacturing needs. The new facility is located in a special
Philippines economic zone (PEZA), which will allow us to take advantage of
certain tax benefits. In Manila, we also operate certain back-end LCD functions
pursuant to a sub-assembly agreement with Technology Electronic Assembly and
Management Pacific Corporation, or TEAM. Those services are performed in
TEAMs buildings, but during 2002 all functions will be transferred to our own
Carmelray facility.

Our Beijing facility is a high-volume display module manufacturing
facility similar to our facility in Manila. We own the manufacturing facility
in Beijing, which we completed in 1999, and all of the equipment in that
facility. In addition, we employ all of the direct and indirect manufacturing
employees at the facility, including technicians, supervisors, and engineers.

Quality Control

We recognize the need to maintain a strong reputation for quality as a
means of retaining existing customers and securing additional orders from them
as well as attracting new customers. We have an extensive quality control
program and maintain at each of our facilities quality systems and processes
that meet or exceed the demanding standards set by many leading OEMs in our
targeted industries. We base our quality control program upon statistical
process control, which advocates continual quantitative measurements of crucial
parameters and uses those measurements in a closed-loop feedback system to
control the manufacturing process. We perform product life testing to help
ensure long-term product reliability. We analyze results of product life tests
and take actions to refine the manufacturing process or enhance the product
design.

Increased global competition has led to increased customer expectations
with respect to price, delivery, and quality. Customers often evaluate price
in the quotation process and evaluate delivery and quality only after receiving
the product. Therefore, many customers preview a companys quality by viewing
the quality systems employed. We have received ISO 9001 and QS 9000
certification of our new Manila manufacturing facility and ISO 9001
certification of our manufacturing facility and corporate headquarters in
Tempe, Arizona. ISO and QS are quality standards established by international
organizations that attempt to ensure that the processes used in development and
production remain consistent. This is accomplished through documentation
maintenance, training, and management review of the processes used. Although
achieving an ISO or QS certification does not assure that we will obtain future
business, it is a factor that enables our customers to recognize that our
production processes meet these established, global standards of performance.

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Components and Raw Materials

Components and raw materials constitute a substantial portion of our
product costs. The principal components and raw materials we use in producing
our displays consist of LCD glass, silicon wafers (for LCoSmicrodisplays),
application specific integrated circuits, or ASICs, circuit boards, molded
plastic parts, lead frames, and packaging materials. Our procurement strategy
is to secure alternative sources of supplies for the majority of these
materials. Many of these materials, however, must be obtained from foreign
suppliers, which subjects us to the risks inherent in obtaining materials from
foreign sources, including supply interruptions and currency fluctuations. Our
suppliers generally are meeting our requirements, and we believe our strategic
supplier alliances have further strengthened our relations with offshore
suppliers. We experienced material shortages of ASICs in 1999 and 2000 as a
result of the increased worldwide demand for cellular handsets and as a result
of supplier issues encountered in the fourth quarter of 2000. These shortages
prevented us from meeting customer demand for certain of our products. Similar
shortages in the future could have a material adverse effect on our business.

Research, Development, and Engineering

We conduct an active and ongoing research, development, and engineering
program that focuses on advancing technology, developing improved design and
manufacturing processes, and improving the overall quality of the products and
services that we provide. Our goal is to provide our customers with new
solutions that address their needs. Research and development personnel
concentrate on improving the performance of current products and expanding the
technology to serve new markets. We also conduct research and development in
manufacturing processes, including those associated with efficient, high-volume
production and electronic packaging.

We are also focusing our research and development efforts on new display
technologies. We expect that these advanced display technologies will enable
us to provide our customers with differentiating products or products that
provide higher information content. These new technologies include active
addressing, sunlight readable LCDs, color LCDs, plastic LCDs, bi-stable LCDs,
graphics and color graphics, organic emitting displays, and pixel-related
display technologies. These products may be available for use in custom
devices or in standard devices. We have undertaken a significant research and
development program and made substantial investments with respect to the
development of our LCoSmicrodisplays. The majority of our available research
and development personnel hours was dedicated to LCoSmicrodisplays in 2001,
and we expect that to continue in 2002.

Intellectual Property

We rely on a variety of intellectual property methods, including patents,
trade secrets, trademarks, confidentiality agreements, licensing agreements,
and other forms of contractual provisions, to protect and advance our
intellectual property. Although our existing LCD display business has not
historically depended on intellectual property protection, we are manufacturing
more advanced display products for which we are actively seeking intellectual
property protection. We have also applied for numerous other process, product,
and design patents, all related to display technologies. There can be no
assurance that any of these patents will be issued to us.

We have also taken several steps to both protect and advance our LCoS
microdisplay technology.



| |  |  | We have filed numerous patents relating to our LCoS
microdisplay technology. These patents cover the areas of product
design and manufacturing process technology. We have a strong
emphasis in this area and expect to continue to file additional
disclosures.                                                                                                                                                                                                                                                                                                                                                                                                 
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | In July 1999, we purchased the assets, including all
production and test equipment, specialized laboratory equipment, and
supporting design documentation and software, of the former Light
Valve business unit of National Semiconductor. We also hired
several key scientists of that business unit and acquired an
exclusive, paid-up, royalty free license on all of the patents and
intellectual property related to that business unit. This license
covers all intellectual property relating to the processing,
packaging, and testing of light valves and the integrated circuits
necessary to manufacture and sell both light valves and light
engines.
|
| |  |  | In August 1999, we licensed the microdisplay technology of
S-Vision Corporation, a former microdisplay competitor that had
recently ceased operations. Under this agreement, we acquired an
irrevocable, royalty free, fully paid-up, worldwide license to the
intellectual property associated with                                                                                                                                                                                                                                                                                                                                                             

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| |   |  | S-Visions digital backplane and optical systems, which provides us
rights to manufacture certain microdisplay products and patented
optical engines. In addition, S-Vision assigned to us a patent
relating to the design and manufacture of microdisplay products.                                                   
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | In January 2002, we purchased the intellectual property of
Zight Corporation, a private company that focused on microdisplays
for personal display system applications. In addition, we purchased
certain key assets of Zights at a creditors auction and hired six
key technical persons formerly employed by Zight.

Competition

We believe that Philips, Samsung, Seiko-Epson, Hosiden, Optrex, Seiko
Instruments, Wintek, and Sharp constitute the principal competitors for our
direct view display products. Most of these competitors are large companies
that have greater financial, technical, marketing, manufacturing, vertical
integration, and personnel resources than we do. Our sales, profitability, and
success depend substantially upon our ability to compete with other providers
of display modules. We cannot provide assurance that we will continue to be
able to compete successfully with these organizations. We currently compete
principally on the basis of the technical innovation, engineering service, and
performance of our display modules, including their ease of use and
reliability, as well as on their cost, timely design, and manufacturing and
delivery schedules. Our competitive position could be adversely affected if
one or more of our customers determines to design and manufacture their display
modules internally or secures them from other parties.

We believe that Texas Instruments, JVC, Hitachi, Aurora Systems, Epson,
and Sony constitute the principal competitors for our microdisplay products.
Texas Instruments has developed a product, referred to as a DMD microdisplay,
that competes with our LCoStechnology. JVC, Hitachi, and Aurora are producing
a similar liquid crystal on silicon display based on their own technology.
Epson and Sony manufacture transmissive polysilicon, which is a type of
microdisplay that can be used in some of the same applications as LCoS
microdisplays. Numerous other established and start-up companies are also
pursuing similar and related technologies that may compete with our LCoS
technology.

Environmental Regulations

Our operations create a small amount of hazardous waste, including various
epoxies, gases, inks, solvents, and other wastes. The amount of hazardous
waste we produce may increase in the future depending on changes in our
operations. The general issue of the disposal of hazardous waste has received
increasing focus from federal, state, local, and international governments and
agencies and has been subject to increasing regulation.

In 1991, we received a notice of potential liability at the
Barkhamsted-New Hartford Landfill Site (the Landfill) in Barkhamsted,
Connecticut from the United States Environmental Protection Agency (EPA).
Fifty-seven other entities received similar letters. In January 1992, we
received a 104(e) questionnaire from the EPA which was completed and submitted
during 1992. We received verbal notification that we had no further liability
in the matter. According to the EPA, groundwater contamination at the site,
which includes volatile and semi-volatile organic compounds and low
concentrations of metals, constitutes a low-level threat. As a result of
previous actions at the site, groundwater is the only medium requiring
additional cleanup. All source material and principal threats have been
addressed through the landfill capping and related activity completed in 1999.
On February 28, 2002, we received notification from the EPA that the EPA
believes we are an involved party and indicated that the EPA was seeking to
negotiate an agreement with the involved parties to fund the EPAs chosen
remedy of monitored natural attenuation of the groundwater. The EPA indicated
that further notification would be made in the next 60 days, which notification
will include the names of any other involved parties. We are evaluating our
potential liability at the site. The Landfill is a semi-active waste disposal
area consisting of 97.84 acres located in Barkhamsted and New Hartford,
Connecticut. The Landfill is owned and operated by the Administrative Board of
Regional Refuse Disposal and began operating as a landfill in 1974. Industrial
wastes were received by the Landfill until 1993, and the Landfill was closed in
1995. The EPA has conducted a Remedial Investigation/Feasibility Study and
issued a Proposed Plan to clean up the site.

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Employees

As of December 31, 2001, we employed a total of 1,500 persons, of whom
seven were employed through third-party contracts. Of our direct employees,
233 were employees at our principal U.S. facility in Arizona and U.S. sales
offices; 739 were employees at our manufacturing facility in Manila; 516 were
employees at our manufacturing facility in Beijing; and five were employees at
our Three-Five Systems Limited subsidiary in Swindon, England. We consider our
relationship with our employees to be good, and none of our employees currently
are represented by a union in collective bargaining with us.

In 2001, TEAM provided some of the personnel engaged in the back-end
assembly of our LCD panels in Manila under a sub-assembly agreement between us
and TEAM. As of December 31, 2001, 361 persons performed direct labor
operations at the Manila facility through this sub-assembly agreement with
TEAM.

Executive Officers

The following table sets forth certain information regarding our executive officers:

|                    |  |     |    |               |  |                                                                                      
|------------------- |  | --- | -- | ------------- |  | -------------------------------------------------------------------------------------
|Name                |  | Age |    | Position Held
|                    |  |     |    |              
|Jack L. Saltich     |  |     | 58 |               |  | President, Chief Executive Officer, and Director                                     
|                   
|                   
|                   
|                   
|Jeffrey D. Buchanan |  |     | 46 |               |  | Executive Vice President, Chief Financial Officer,
Secretary, Treasurer, and Director
|                   
|                   
|                   
|                   
|Carl E. Derrington  |  |     | 51 |               |  | Vice President, Chief Manufacturing Officer                                          
|                   
|                   
|                   
|                   
|Robert L. Melcher   |  |     | 62 |               |  | Chief Technology Officer                                                             
|                   
|                   
|                   
|                   
|Robert T. Berube    |  |     | 63 |               |  | Principal Accounting Officer and Corporate Controller                                
|                   
|                   
|                   
|                   
|Robert W. Harrison  |  |     | 40 |               |  | Vice President, Direct View Display Business Unit Manager                            
|                   
|                   
|                   
|                   
|Tom Miller          |  |     | 52 |               |  | General Manager, Three-D OLED                                                        

Jack L. Saltichhas served as a director and the President and Chief
Executive Officer of our company since July 1999. Mr. Saltich served as Vice
President of Advanced Micro Devices from May 1993 until July 1999; as Executive
Vice President of Applied Micro Circuits Corp. from January 1991 until March
1993; and as Vice President of VLSI from July 1988 until January 1991. Mr.
Saltich held a variety of executive positions for Motorola from July 1971 until
June 1988. These positions included serving as an Engineering Manager from May
1974 until January 1980, an Operation Manager from January 1980 until May 1982,
a Vice President and Director of the Bipolar Technology Center from May 1982
until June 1986, and a Vice President and Director of the Advanced Product
Research and Development Laboratory from June 1986 until June 1988.

Jeffrey D. Buchananhas served as a director and Executive Vice President
of our company since June 1998; as Chief Financial Officer and Treasurer since
June 1996; and as Secretary since May 1996. Mr. Buchanan served as our Vice
President  Finance, Administration, and Legal from June 1996 until July 1998
and as our Vice President  Legal and Administration from May 1996 to June
1996. Mr. Buchanan served from June 1986 until May 1996 as a business lawyer
with OConnor, Cavanagh, Anderson, Killingsworth & Beshears. Mr. Buchanan was
associated with the international law firm of Davis Wright Tremaine from 1984
to 1986, and he was a senior staff person at Deloitte & Touche from 1982 to
1984.

Carl E. Derringtonhas been our Chief Manufacturing Officer since May
1999. Dr. Derrington joined our company in 1986 as a Director of Research and
Development. Since that time, Dr. Derrington has served as a Plant Manager
from January 1986 until September 1987, a Director of Engineering from
September 1987 until August 1989, a Director of Manufacturing from August 1989
until April 1996, and a Director of Manufacturing Engineering from April 1996
until April 1999.

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Robert L. Melcherhas been our Chief Technology Officer since October
1999. Prior to joining our company, Dr. Melcher was employed at IBM in a
variety of management positions since 1970. He served as the Program Leader
for Projection Displays from 1993 to 1999 and immediately prior to that he was
Director of the Physical Sciences Department from 1990 to 1993.

Robert T. Berubehas been our Principal Accounting Officer since July 1998
and has served as our Corporate Controller since July 1990. Mr. Berube served
as Chief Financial Officer of Electronic Research Associate, Inc., a
manufacturing company, from July 1977 until April 1990.

Robert Harrisonhas been Vice President of the Direct View Display Group
since January of 2001. From July 1999 to December 2000 he was Vice President of
Sales and Marketing for the Direct View Display Group. From September 1998 to
July 1999 Mr. Harrison was a principal at Harcom International, a display
consultant and market research firm. From April 1996 to August 1998 Mr.
Harrison was General Manager of the LCD Division of Hyundai Electronics
America. He served as Senior Regional Sales Manager for Three-Five Systems from
January 1995 to April 1996. Previously, he held positions with Optrex, an LCD
manufacturing company, from August 1988 to 1995, including Regional Sales
Manager from August 1988 to December 1990 and National Accounts Manager from
January 1991 to January 1995.

Tom Millerhas been General Manager of Three-D OLED since July 2001.
Previously, he was VP Sales and Marketing for Silicon Motion, Inc., from
December 2000 until July 2001. Mr. Miller was a principal partner at
Sapiential Prime, a management consulting company to high technology start-ups
from April 1998 until December 2000. He was founder and CEO of Quantum 3D, a
provider of high-end 3D graphics boards from April 1996 until April 1998. From
May 1973 to April 1996, Mr. Miller held a variety of management positions,
including Vice President of Marketing for Fujitsu Microelectronics, interim
Chairman and CEO of SPARC International, an industry consortium, Chairman and
CEO of VIA Technologies, Vice President of Sales and Marketing for Integrated
CMOS Systems, and executive positions at Fairchild Semiconductor, NCR
Microelectronics and Texas Instruments.

SPECIAL CONSIDERATIONS

You should carefully consider the following factors, in addition to those
discussed elsewhere in this report, in evaluating our company and our business.

Motorola accounts for a significant portion of our sales.

Our revenue depends to a significant extent on maintaining Motorolas
business as well as Motorolas success in the mobile handset business,
particularly in the various major mobile handset programs in which we
participate. Any material delay, cancellation, or reduction of orders from
Motorola could have a material adverse effect on our business.

Motorola, including its subcontractors, has been our largest customer
during each of the last six years. Sales of Motorola products accounted for
approximately 85.4% of our net sales in 2001, 86.9% in 2000, 86.1% in 1999,
63.6% in 1998, 34.6% in 1997, and 65.1% in 1996. Substantially all of our
sales of Motorola products were for mobile handset applications. During 2001,
the three largest of these product programs accounted for a total of 75.8% of
our net sales, with the largest program accounting for 57.2% of our net sales.

A significant decline in sales to Motorola is expected to occur in 2002
primarily as a result of receiving no new design wins in 2001 in its handset
business. Further unexpected reductions could also occur at any time. For
example, an unexpected reduction in Motorola mobile handset programs reduced
our net sales to Motorola from $73.7 million in 1995 to $39.5 million in 1996
and $29.2 million in 1997. Since Motorola has no long-term contractual
commitments to purchase any of our products, we could experience similar
declines in our net sales at any time. If we do not receive any additional
design wins in 2002 in Motorolas handset business, additional significant
declines in sales to Motorola could occur in 2003.

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Our revenue may decline significantly during 2002

The year 2001 was characterized by a worldwide lack of growth in the
handset market and excess LCD capacity. As a result, some OEMs expected LCD
modules used in low-end handsets to be sold below industry costs. We have made
the strategic decision, however, not to sell our products below standard
industry costs. Instead, we are focusing on lower-volume, higher-priced
products that utilize our advanced technologies and engineering services. As a
result of our strategic decision, however, our volume of unit shipments and,
consequently, our revenue, may decline significantly.

Our emerging microdisplay business may not be successful.

A key element of our current business plan involves the commercialization
of our microdisplay technology. The success of this effort depends on numerous
factors. As a result, we could be unable to expand our business as we
currently anticipate and may make substantial investments in product
development, manufacturing, and marketing efforts that may not result in
microdisplay sales.

Manufacturing an LCoSmicrodisplay involves a significantly different
procedure than manufacturing a typical liquid crystal display. Although we
added additional equipment to our Arizona manufacturing facility in the last
two years for manufacturing LCoSmicrodisplays, the manufacture of
microdisplays will require us to overcome numerous challenges, including the
following:



| |  |  | the use of new materials, including silicon;                                        
| | - |  | ------------------------------------------------------------------------------------
|
| |  |  | the modification of equipment and processes to accommodate the round silicon wafers;
|
| |  |  | the implementation of new manufacturing techniques;                                 
|
| |  |  | the incorporation of new handling procedures;                                       
|
| |  |  | the maintenance of cleaner manufacturing environments; and                          
|
| |  |  | the ability to master tighter tolerances in the manufacturing process.              

We experienced significant issues in commencing volume production of LCoS
microdisplays in 2001, and those issues could continue through 2002. These
issues could result in the delay of the full implementation of high-volume LCoS
microdisplay production. In addition, we experienced lower than expected
manufacturing yields in LCoSmicrodisplays. Continued lower than expected
manufacturing yields could significantly and adversely affect us because of the
relatively high cost of the silicon backplanes used in LCoSmicrodisplays.

Various target markets for our microdisplays, including projectors,
monitors, digital and high-definition televisions, and portable microdisplays,
are uncertain, may be slow to develop, or could utilize competing technologies,
especially polysilicon and DMDs. Many manufacturers have well-established
positions in these markets. As a result, we must provide customers with lower
cost, comparable performance microdisplays for their products. Digital and
high-definition television has only recently become available to consumers, and
widespread market acceptance is uncertain. Penetrating this market will
require us to offer an improved value proposition to existing technology. In
addition, the commercial success of the portable microdisplay market is
uncertain. Gaining acceptance in this market may prove difficult because of
the radically different approach of microdisplays to the presentation of
information. The failure of any of these target markets to develop as we
expect, or our failure to penetrate these markets, will impede our anticipated
sales growth. Even if our technology successfully meets our price and
performance goals, our customers may not achieve commercial success in selling
their products that incorporate our microdisplay technology.

We face intense competition.

We serve intensely competitive industries that are characterized by price
erosion, rapid technological change, and competition from major domestic and
international companies. In 2001, some OEM customers began expecting to
purchase LCD modules at prices below industry costs, and many of our
competitors agreed to those requests. Continued competition of this kind could
result in additional pricing pressures, lower sales, reduced margins, and lower
market share.

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Many of our competitors have greater market recognition, larger customer
bases, and substantially greater financial, technical, marketing, distribution,
and other resources than we possess. As a result, they may be able to
introduce new products and respond to customer requirements more quickly than
we can.

Our competitive position could suffer if one or more of our customers
decide to design and manufacture their own display modules, to use standard
devices, to contract with our competitors, or to use alternative technologies.
In addition, our customers typically develop a second source, even for displays
we design for them. These second source suppliers may win an increasing share
of a program, particularly as it grows and matures, by competing primarily on
price rather than on design capability.

Our ability to compete successfully depends on a number of factors, both
within and outside our control. These factors include the following:



| |  |  | our success in designing and manufacturing new product
solutions, including those implementing new technologies;                                                                                                                              
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our ability to address the needs of our customers;                                                                                                                                                                                            
|
| |  |  | the pricing, quality, performance, reliability, features,
ease of use, and diversity of our product solutions;                                                                                                                                
|
| |  |  | foreign currency devaluations, especially in Asian
currencies, such as the Japanese yen, the Korean won and the
Taiwanese dollar, which may cause a foreign competitors products to
be priced significantly lower than our product solutions;
|
| |  |  | the quality of our customer services;                                                                                                                                                                                                         
|
| |  |  | our efficiency of production;                                                                                                                                                                                                                 
|
| |  |  | the rate at which customers incorporate our product solutions into their own products; and                                                                                                                                                    
|
| |  |  | product or technology introductions by our competitors.                                                                                                                                                                                       

We are subject to lengthy development periods and product acceptance cycles.

We sell our display modules to OEMs, which then incorporate them into the
products they sell. OEMs make the determination during their product
development programs whether to incorporate our display modules or pursue other
alternatives. This requires us to make significant investments of time and
capital in the custom design of display modules well before our customers
introduce their products incorporating these displays and before we can be sure
that we will generate any significant sales to our customers or even recover
our investment. During a customers entire product development process, we
face the risk that our display will fail to meet our customers technical,
performance, or cost requirements or will be replaced by a competing product or
alternative technological solution. Even if we complete our design process in
a manner satisfactory to our customer, the customer may delay or terminate its
product development efforts. The occurrence of any of these events would
adversely affect our operating results. The lengthy development period also
means that it is difficult to immediately replace an unexpected loss of
existing business.

We do not have long-term purchase commitments from our customers.

Our customers, including Motorola, generally do not provide us with firm,
long-term volume purchase commitments. In addition, the worldwide adverse
economic slowdown in 2001 led to radically shortened lead times on purchase
orders. Although we sometimes enter into manufacturing contracts with our
customers, these contracts clarify order lead times, inventory risk allocation,
and similar matters rather than provide firm, long-term volume purchase
commitments. As a result, customers can generally cancel purchase commitments
or reduce or delay orders at any time. The cancellation, delay, or reduction
of customer commitments could result in our holding excess and obsolete
inventory or having unabsorbed manufacturing overhead. The large percentage of
our sales to customers in the electronics industry, which is subject to severe
competitive pressures, rapid technological change, and product obsolescence,
increases our inventory and overhead risks.

Our operating results have been materially and adversely affected in the
past as a result of the failure to obtain anticipated orders and deferrals or
cancellations of purchase commitments because of changes in customer

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requirements. For example, we have made announcements in the past that
sales would not meet our expectations because of delays in customer programs.
This problem was exacerbated in 2001 because of the limited visibility and
shortened lead-time of purchase orders from our customers.

We depend on the market acceptance of the products of our customers.

We do not sell any products to end users. Instead, we design and
manufacture various product solutions that our customers incorporate into their
products. As a result, our success depends almost entirely upon the widespread
market acceptance of our customers products. Any significant slowdown in the
demand for our customers products would adversely affect our business.

Because our success depends on the widespread market acceptance of our
customers products, we must identify industries that have significant growth
potential and establish relationships with OEMs in those industries. Our
failure to identify potential growth opportunities or establish relationships
with OEMs in those industries would adversely affect our business.

Our dependence on the success of the products of our customers exposes us
to a variety of risks, including the following:



| |  |  | our ability to provide significant design and manufacturing
services for customers on a timely and cost-effective basis;                    
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our success in maintaining customer satisfaction with our
design and manufacturing services;                                                
|
| |  |  | our ability to match our design and manufacturing capacity
with customer demand and to maintain satisfactory delivery
schedules;            
|
| |  |  | customer order patterns, changes in order mix, and the level
and timing of orders placed by customers that we can complete in a
quarter; and
|
| |  |  | the cyclical nature of the industries and markets we serve.                                                                                 

Our failure to address these risks may cause our sales to decline.

Shortages of components and materials may delay or reduce our sales and
increase our costs.

Our inability to obtain sufficient quantities of components and other
materials necessary to produce our displays could result in reduced or delayed
sales or lost orders. Any delay in or loss of sales could adversely impact our
operating results. We obtain many of the materials we use in the manufacture
of our displays from a limited number of foreign suppliers, particularly
suppliers located in Asia, and we do not have long-term supply contracts with
any of them. As a result, we are subject to economic instability and currency
fluctuations in these Asian countries as well as to increased costs, supply
interruptions, and difficulties in obtaining materials. Our customers also may
encounter difficulties or increased costs in obtaining from others the
materials necessary to produce their products into which our product solutions
are incorporated.

Materials and components for some of our major programs from time to time
have been subject to allocation because of shortages of these materials and
components. During 1998, we occasionally delayed sales of our LCD modules as a
result of the unavailability of LCD polarizers and IC drivers, or ASICs.
During 1999, we experienced difficulties obtaining our requirements for ASICs
as a result of a worldwide shortage. We also experienced a material supply
interruption in ASICs for a key program in the fourth quarter of 2000. These
shortages resulted in lost sales opportunities. Similar shortages in the
future could have a material adverse effect on our business.

We must maintain satisfactory manufacturing yields and capacity.

Our inability to maintain high levels of productivity or satisfactory
delivery schedules at our manufacturing facilities in Manila, Beijing, or
Arizona would adversely affect our operating results. The design and
manufacture of LCDs and display modules are highly complex processes that are
sensitive to a wide variety of factors, including the level of contaminants in
the manufacturing environment, impurities in the materials used, and the
performance

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of personnel and equipment. As is typical in the industry, at times we
have experienced lower than anticipated manufacturing yields and lengthening of
delivery schedules. We may encounter lower manufacturing yields and longer
delivery schedules as we ramp our high-volume LCD line in Asia and as we
manufacture LCoSmicrodisplays in higher volumes. In addition, the complexity
of manufacturing processes will increase along with increases in the
sophistication of display modules.

We are in the process of moving our Arizona LCD line to Asia. We will face
the risks inherent in constructing, equipping, and commencing operations in
that new LCD facility. These risks include the following:



| |  |  | the ability to identify and acquire or lease suitable property;                         
| | - |  | ----------------------------------------------------------------------------------------
|
| |  |  | construction delays and cost overruns;                                                  
|
| |  |  | the ability to procure and install necessary additional equipment;                      
|
| |  |  | the ability to hire, train, and manage manufacturing personnel; and                     
|
| |  |  | production delays, unfavorable manufacturing yields, and lengthening delivery schedules.

Any problems with our other manufacturing operations could result in the
lengthening of our delivery schedules, reductions in the quality or performance
of our design and manufacturing services, and reduced customer satisfaction.

Our business depends on new products and technologies.

We operate in rapidly changing industries. Technological advances, the
introduction of new products, and new design and manufacturing techniques could
adversely affect our business unless we are able to adapt to the changing
conditions. As a result, we will be required to expend substantial funds for
and commit significant resources to:



| |  |  | continue research and development activities on existing and potential product solutions;
| | - |  | -----------------------------------------------------------------------------------------
|
| |  |  | engage additional engineering and other technical personnel;                             
|
| |  |  | purchase advanced design, production, and test equipment; and                            
|
| |  |  | expand our manufacturing capacity.                                                       

Our future operating results will depend to a significant extent on our
ability to continue to provide new product solutions that compare favorably on
the basis of time to introduction, cost, and performance with the design and
manufacturing capabilities of OEMs and competitive third-party suppliers. Our
success in attracting new customers and developing new business depends on
various factors, including the following:



| |  |  | utilization of advances in technology;                                   
| | - |  | -------------------------------------------------------------------------
|
| |  |  | innovative development of new solutions for customer products;           
|
| |  |  | efficient and cost-effective services; and                               
|
| |  |  | timely completion of the design and manufacture of new product solutions.

Our efforts to develop new technologies may not result in commercial success.

Our research and development efforts with respect to new technologies may
not result in customer or widespread market acceptance. Some or all of those
technologies may not successfully make the transition from the research and
development lab to cost-effective production as a result of technology
problems, competitive cost issues, yield problems, and other factors. Even
when we successfully complete a research and development effort with respect to
a particular technology, our customers may determine not to introduce or may
terminate products utilizing the technology for a variety of reasons, including
the following:



| |  |  | difficulties with other suppliers of components for the products;
| | - |  | -----------------------------------------------------------------
|
| |  |  | superior technologies developed by our competitors;              

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| |  |  | price considerations;                                            
| | - |  | -----------------------------------------------------------------
|
| |  |  | lack of anticipated or actual market demand for the products; and
|
| |  |  | unfavorable comparisons with products introduced by others.      

The nature of our business requires us to make capital expenditures and
investments for new technologies. For example, our capital acquisition value
of the assets, including tooling and licenses, for LCoSmicrodisplays,
currently our largest research and development effort, was $14.8 million
through December 31, 2001. To facilitate the development of our LCoS
microdisplay products, we also made an equity investment of $3.8 million in
Inviso, Inc., which we had to write off in 2001 as a result of the closing of
those operations. In addition, we purchased assets and technology of the
former Light Valve business unit of National Semiconductor Corporation for
approximately $3.6 million during 1999 and the technology and certain assets of
Zight Corporation for approximately $2.6 million in early 2002. We also
invested $1.3 million in a microdisplay component related start-up company,
Silicon Bandwidth, Inc., during 2001. We may be required to make similar
investments and acquisitions in the future to maintain or enhance our ability
to offer technological solutions.

Significant expenditures relating to one or more new technologies,
especially LCoSmicrodisplays, that ultimately prove to be unsuccessful for any
reason could have a material adverse effect on us. In addition, any
investments or acquisitions made to enhance our technologies may prove to be
unsuccessful.

We face risks associated with international operations.

Our manufacturing operations in Manila, Beijing, and Arizona and our sales
and distribution operations in Europe and Asia create a number of logistical
and communications challenges. Our international operations also expose us to
various economic, political, and other risks, including the following:



| |  |  | management of a multi-national organization;                                                             
| | - |  | ---------------------------------------------------------------------------------------------------------
|
| |  |  | compliance with local laws and regulatory requirements as
well as changes in those laws and requirements;
|
| |  |  | employment and severance issues;                                                                         
|
| |  |  | overlap of tax issues;                                                                                   
|
| |  |  | tariffs and duties;                                                                                      
|
| |  |  | possible employee turnover or labor unrest;                                                              
|
| |  |  | lack of developed infrastructure;                                                                        
|
| |  |  | the burdens and costs of compliance with a variety of foreign laws; and                                  
|
| |  |  | political or economic instability in certain parts of the world.                                         

Changes in policies by the United States or foreign governments resulting
in, among other things, increased duties, higher taxation, currency conversion
limitations, restrictions on the transfer or repatriation of funds, limitations
on imports or exports, or the expropriation of private enterprises also could
have a material adverse effect on us. Any actions by our host countries to
reverse policies that encourage foreign investment or foreign trade also could
adversely affect our operating results. In addition, U.S. trade policies, such
as most favored nation status and trade preferences for certain Asian
nations, could affect the attractiveness of our services to our U.S. customers.

We depend on our operations in Arizona.

Our Arizona facility and its high-volume LCoSmicrodisplay manufacturing
line are critical to our success. We intend, at least initially, to produce
all of our LCoSmicrodisplays on this dedicated line. This facility also
houses our principal research, development, engineering, design, and managerial
operations. Any event that causes a disruption of the operation of this
facility for even a relatively short period of time would adversely affect our
ability to provide both technical and manufacturing support for our customers,
especially our microdisplay customers.

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We depend on our manufacturing operations in the Philippines.

Any disruption or termination of our manufacturing operations in Manila or
air transportation with the Philippines, even for a relatively short period of
time, would adversely affect our operations. The Philippines have been subject
to volcanic eruptions, typhoons, and substantial civil disturbances, including
attempted military coups against the government, since we commenced operations
there in 1986. Capital investments in the Philippines amounted to
approximately $18.0 million through December 31, 2001. We believe that our
manufacturing operations in Manila constitute one of our most important
resources and that it would be difficult to replace the low-cost,
high-performance facility or the highly trained production staff in the event
of the disruption or termination of our manufacturing operations in Manila.

A small portion of our operations in Manila also depends on the business
and financial condition of the third-party subcontractor that owns a
manufacturing facility that is located on land the subcontractor leases from
the Philippine government. The subcontractor utilizes equipment, processes,
and documentation that we own and supervisory personnel that we employ. The
subcontractor provides us with direct production personnel. The subcontractor
also utilizes additional space in the facility to produce products for other
entities unrelated to us. Any disruption of our relationship with that
subcontractor could adversely affect our ability to provide manufacturing
support for our customers.

We depend on our manufacturing operations in China.

In 1999, we completed the construction of a permanent, high-volume LCD
module manufacturing facility in Beijing, China, which is similar to our Manila
facility. Capital investments in China amounted to approximately $12.7 million
through December 31, 2001.

Our operations and assets are subject to significant political, economic,
legal, and other uncertainties in China. The Chinese government recently has
been pursuing economic reform policies, including the encouragement of foreign
trade and investment and greater economic decentralization. The Chinese
government, however, may not continue to pursue these policies, may not
successfully pursue these policies, or may significantly alter these policies
from time to time. China currently does not have a comprehensive and highly
developed system of laws, particularly with respect to foreign investment
activities and foreign trade. Enforcement of existing and future laws and
contracts is uncertain, and implementation and interpretation of laws may be
inconsistent. As the Chinese legal system develops, the passage of new laws,
changes in existing laws, and the preemption of local regulations by national
laws may adversely affect us. We also could be adversely affected by a number
of other factors, including the following:



| |  |  | the imposition of austerity measures intended to reduce
inflation;                                                                                                       
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | inadequate development or maintenance of infrastructure,
including the unavailability of adequate power and water supplies,
transportation, raw materials, and parts; and
|
| |  |  | a deterioration of the general political, economic, or social
environment in China.                                                                                      

Although China recently joined the World Trade Organization, we cannot be
certain whether or to what extent trade relations with China will continue to
improve. Any developments that adversely affect trade relations between the
United States and China in the future could adversely affect us by increasing
the cost to U.S. customers of products manufactured by us in China.

We face risks associated with international trade and currency exchange.

Political and economic conditions abroad may adversely affect the foreign
manufacture and sale of our displays. Protectionist trade legislation in
either the United States or foreign countries, such as a change in the current
tariff structures, export or import compliance laws, or other trade policies,
could adversely affect our ability to manufacture or sell displays in foreign
markets and to purchase materials or equipment from foreign suppliers.

While we transact business predominantly in U.S. dollars and bill and
collect most of our sales in U.S. dollars, we collect a portion of our revenue
in non-U.S. currencies, such as the Chinese renminbi. In the future, customers
increasingly may make payments in non-U.S. currencies, such as the Euro. In
addition, we account for a

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portion of our costs, such as payroll, rent, and indirect operating costs,
in non-U.S. currencies, including Philippine pesos, British pounds sterling,
and Chinese renminbi.

Fluctuations in foreign currency exchange rates could affect our cost of
goods and operating margins and could result in exchange losses. In addition,
currency devaluation can result in a loss to us if we hold deposits of that
currency. The Philippine peso suffered a major devaluation in late 1997, and
the Chinese renminbi has experienced significant devaluation against most major
currencies in recent years. Hedging foreign currencies can be difficult,
especially if the currency is not freely traded. We cannot predict the impact
of future exchange rate fluctuations on our operating results.

The risks described above are particularly important since sales outside
North America represented 83.2% of our net sales in 2001 and 84.2% of our net
sales in 2000. Sales in foreign markets, primarily Europe and China, to OEMs
based in the United States accounted for almost all of our international sales
in both of these periods.

Variability of customer requirements may adversely affect our operating
results.

Custom manufacturers for OEMs must provide increasingly rapid product
turnaround and respond to ever-shorter lead times. A variety of conditions,
both specific to individual customers and generally affecting the demand for
their products, may cause customers to cancel, reduce, or delay orders.
Cancellations, reductions, or delays by a significant customer or by a group of
customers could adversely affect our business. On occasion, customers require
rapid increases in production, which can strain our resources and reduce our
margins. Although we have increased our manufacturing capacity, we may lack
sufficient capacity at any given time to meet our customers demands if their
demands exceed anticipated levels.

Our operating results have significant fluctuations.

In addition to the variability resulting from the short-term nature of our
customers commitments, other factors contribute to significant periodic and
seasonal quarterly fluctuations in our results of operations. These factors
include the following:



| |  |  | the timing of orders;                                                                      
| | - |  | -------------------------------------------------------------------------------------------
|
| |  |  | the volume of orders relative to our capacity;                                             
|
| |  |  | product introductions and market acceptance of new products or new generations of products;
|
| |  |  | evolution in the life cycles of customers products;                                       
|
| |  |  | timing of expenditures in anticipation of future orders;                                   
|
| |  |  | effectiveness in managing manufacturing processes;                                         
|
| |  |  | changes in cost and availability of labor and components;                                  
|
| |  |  | product mix;                                                                               
|
| |  |  | pricing and availability of competitive products and services; and                         
|
| |  |  | changes or anticipated changes in economic conditions.                                     

Accordingly, you should not rely on the results of any past periods as an
indication of our future performance. It is likely that in some future period,
our operating results may be below expectations of public market analysts or
investors. If this occurs, our stock price may decline.

We must effectively manage our growth.

The failure to manage our growth effectively could adversely affect our
operations. We have increased the number of our manufacturing and design
programs and plan to expand further the number and diversity of our programs in
the future. Our ability to manage our planned growth effectively will require
us to



| |  |  | enhance our operational, financial, and management systems;
| | - |  | -----------------------------------------------------------

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| |  |  | expand our facilities and equipment; and                                                                                                                                    
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | successfully hire, train, and motivate additional employees,
including the technical personnel necessary to operate our
production facilities in Tempe, Manila, and Beijing.

The expansion and diversification of our product and customer base may
result in increases in our overhead and selling expenses. We also may be
required to increase staffing and other expenses as well as our expenditures on
capital equipment and leasehold improvements in order to meet the anticipated
demand of our customers. For example, we plan further expansion of our LCoS
manufacturing capacity. Customers, however, generally do not commit to firm
production schedules for more than a short time in advance. Any increase in
expenditures in anticipation of future orders that do not materialize would
adversely affect our profitability. Customers also may require rapid increases
in design and production services that place an excessive short-term burden on
our resources.

We depend on key personnel.

Our development and operations depend substantially on the efforts and
abilities of our senior management and technical personnel. The competition
for qualified management and technical personnel is intense. The loss of
services of one or more of our key employees or the inability to add key
personnel, including those required for our LCoSmanufacturing facility, could
have a material adverse effect on us. Although we maintain non-competition and
nondisclosure covenants with certain key personnel, we do not have any
fixed-term agreements with, or key person life insurance covering, any officer
or employee.

We must protect our intellectual property, and others could infringe on or
misappropriate our rights.

We believe that our continued success depends in part on protecting our
proprietary technology. Third parties could claim that we are infringing their
patents or other intellectual property rights. In the event that a third party
alleges that we are infringing its rights, we may not be able to obtain
licenses on commercially reasonable terms from the third party, if at all, or
the third party may commence litigation against us. The failure to obtain
necessary licenses or other rights or the institution of litigation arising out
of such claims could materially and adversely affect us.

We rely on a combination of patent, trade secret, and trademark laws,
confidentiality procedures, and contractual provisions to protect our
intellectual property. We seek to protect certain of our technology under
trade secret laws, which afford only limited protection. We face risks
associated with our intellectual property, including the following:



| |  |  | pending patent applications may not be issued;                                                                                                     
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | intellectual property laws may not protect our intellectual property rights;                                                                       
|
| |  |  | third parties may challenge, invalidate, or circumvent any patent issued to us;                                                                    
|
| |  |  | rights granted under patents issued to us may not provide competitive advantages to us;                                                            
|
| |  |  | unauthorized parties may attempt to obtain and use
information that we regard as proprietary despite our efforts to
protect our proprietary rights;
|
| |  |  | others may independently develop similar technology or design
around any patents issued to us; and                                                 
|
| |  |  | effective protection of intellectual property rights may be
limited or unavailable in some foreign countries, such as China, in
which we operate.  

We may not be able to obtain effective patent, trademark, service mark,
copyright, and trade secret protection in every country in which we sell our
products. We may find it necessary to take legal action in the future to
enforce or protect our intellectual property rights or to defend against claims
of infringement. Litigation can be very expensive and can distract our
managements time and attention, which could adversely affect our business. In
addition, we may not be able to obtain a favorable outcome in any intellectual
property litigation.

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The market price of our common stock may be volatile.

The market price of our common stock has been extremely volatile. Our
stock price increased dramatically during the three-year period ended December
31, 1994, but declined significantly during 1995 and 1996. The stock price
increased again during 1997, but declined significantly in 1998. Our stock
price again increased significantly during 1999 and in early 2000, but suffered
a major decline in the second half of 2000. The stock, again, declined in the
first half of 2001. The trading price of our common stock in the future could
continue to be subject to wide fluctuations in response to various factors,
including the following:



| |  |  | variations in our quarterly operating results;                                                                    
| | - |  | ------------------------------------------------------------------------------------------------------------------
|
| |  |  | actual or anticipated announcements of technical innovations
or new product developments by us or our competitors;
|
| |  |  | changes in analysts estimates of our financial performance;                                                      
|
| |  |  | general conditions in the electronics industry; and                                                               
|
| |  |  | worldwide economic and financial conditions.                                                                      

In addition, the stock market has experienced extreme price and volume
fluctuations that have particularly affected the market prices for many
high-technology companies and that often have been unrelated to the operating
performance of these companies. These broad market fluctuations and other
factors may adversely affect the market price of our common stock.

The electronics industry is cyclical.

The electronics industry has experienced significant economic downturns at
various times, characterized by diminished product demand, accelerated erosion
of average selling prices, and production over-capacity. In addition, the
electronics industry is cyclical in nature. We have sought to reduce our
exposure to industry downturns and cyclicality by providing design and
production services for leading companies in rapidly expanding segments of the
electronics industry. From time to time, however, as in 2001, we experience
substantial period-to-period fluctuations in operating results, at least in
part because of general industry conditions or events occurring in the general
economy.

We must finance the growth of our business and the development of new products.

To remain competitive, we must continue to make significant investments in
research and development, equipment, and facilities. As a result of the
increase in fixed costs and operating expenses related to these capital
expenditures, our failure to increase sufficiently our net sales to offset
these increased costs would adversely affect our operating results.

From time to time, we may seek additional equity or debt financing to
provide for the capital expenditures required to maintain or expand our design
and production facilities and equipment. We cannot predict the timing or
amount of any such capital requirements at this time. If such financing is not
available on satisfactory terms, we may be unable to expand our business or to
develop new business at the rate desired and our operating results may suffer.
Debt financing increases expenses and must be repaid regardless of operating
results. Equity financing could result in additional dilution to existing
stockholders.

Potential strategic alliances may not achieve their objectives.

We have entered into various strategic alliances, such as our alliances
with DuPont Displays for OLEDs and Synaptics, Inc., and we plan on entering
into other similar types of alliances. Among other matters, we will explore
strategic alliances designed to enhance or complement our technology or to work
in conjunction with our technology; to increase our manufacturing capacity; to
provide necessary know-how, components, or supplies; and to develop, introduce,
and distribute products utilizing our technology. Any strategic alliances may
not achieve their strategic objectives, and parties to our strategic alliances
may not perform as contemplated.

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##### Table of Contents



Any acquisitions that we undertake could be difficult to integrate, disrupt our
business, dilute stockholder value, and harm our operating results.

We expect to review opportunities to buy other businesses or technologies
that would complement our current products, expand the breadth of our markets,
enhance our technical capabilities, or otherwise offer growth opportunities.
While we have no current agreements or negotiations underway, we may buy
businesses, products, or technologies in the future. If we make any future
acquisitions, we could issue stock that would dilute existing stockholders
percentage ownership, incur substantial debt, or assume contingent liabilities.
Our experience in acquiring other businesses and technologies is limited.
Potential acquisitions also involve numerous risks, including the following:



| |  |  | problems assimilating the purchased operations, technologies, or products;                 
| | - |  | -------------------------------------------------------------------------------------------
|
| |  |  | unanticipated costs associated with the acquisition;                                       
|
| |  |  | diversion of managements attention from our core businesses;                              
|
| |  |  | adverse effects on existing business relationships with suppliers and customers;           
|
| |  |  | risks associated with entering markets in which we have no or limited prior experience; and
|
| |  |  | potential loss of key employees of purchased organizations.                                

We cannot assure you that we would be successful in overcoming problems
encountered in connection with such acquisitions, and our inability to do so
could adversely affect our business.

We are subject to environmental regulations.

Our operations result in the creation of small amounts of hazardous waste,
including various epoxies, gases, inks, solvents, and other wastes. Any
failure by us to control the use, or adequately restrict the discharge, of
hazardous substances could subject us to future liabilities. We are subject to
federal, state, and local governmental regulations related to the use, storage,
discharge, and disposal of toxic, volatile, or otherwise hazardous chemicals
used in our design and manufacturing processes. The amount of hazardous waste
produced by us may increase in the future depending on changes in our
operations. Our failure to comply with present or future environmental
regulations could result in the imposition of fines, suspension of production,
or a cessation of operations. Compliance with these regulations could require
us to acquire costly equipment or to incur other significant expenses.

In 1991, we received a notice of potential liability at the
Barkhamsted-New Hartford Landfill Site (the Landfill) in Barkhamsted,
Connecticut from the United States Environmental Protection Agency (EPA).
Fifty-seven other entities received similar letters. In January 1992, we
received a 104(e) questionnaire from the EPA which was completed and submitted
during 1992. We received verbal notification that we had no further liability
in the matter. According to the EPA, groundwater contamination at the site,
which includes volatile and semi-volatile organic compounds and low
concentrations of metals, constitutes a low-level threat. As a result of
previous actions at the site, groundwater is the only medium requiring
additional cleanup. All source material and principal threats have been
addressed through the landfill capping and related activity completed in 1999.
On February 28, 2002, we received notification from the EPA that the EPA
believes we are an involved party and indicated that the EPA was seeking to
negotiate an agreement with the involved parties to fund the EPAs chosen
remedy of monitored natural attenuation of the groundwater. The EPA indicated
that further notification would be made in the next 60 days, which notification
will include the names of any other involved parties. We are evaluating our
potential liability at the site. The Landfill is a semi-active waste disposal
area consisting of 97.84 acres located in Barkhamsted and New Hartford,
Connecticut. The Landfill is owned and operated by the Administrative Board of
Regional Refuse Disposal and began operating as a landfill in 1974. Industrial
wastes were received by the Landfill until 1993, and the Landfill was closed in
1995. The EPA has conducted a Remedial Investigation/Feasibility Study and
issued a Proposed Plan to clean up the site. See Description of
Business-Environmental Regulation contained in Item 1 of this report.

24



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##### Table of Contents



Change in control provisions may adversely affect existing stockholders.

Our restated certificate of incorporation and the Delaware General
Corporation Law contain provisions that may have the effect of making more
difficult or delaying attempts by others to obtain control of our company, even
when these attempts may be in the best interests of stockholders. Our restated
certificate also authorizes the board of directors, without stockholder
approval, to issue one or more series of preferred stock, which could have
voting and conversion rights that adversely affect or dilute the voting power
of the holders of common stock. Delaware law also imposes conditions on
certain business combination transactions with interested stockholders.

We have also adopted a stockholders rights plan intended to encourage
anyone seeking to acquire our company to negotiate with our board of directors
prior to attempting a takeover. While the plan was designed to guard against
coercive or unfair tactics to gain control of our company, the plan may have
the effect of making more difficult or delaying any attempts by others to
obtain control of our company.

We do not pay cash dividends.

We have never paid any cash dividends on our common stock and do not
anticipate that we will pay cash dividends in the foreseeable future. Instead,
we intend to apply earnings to the expansion and development of our business.




ITEM 2.    PROPERTIES

We own and occupy a 97,000 square foot facility in Tempe, Arizona, which
houses our U.S.-based manufacturing operations and our research, development,
engineering, design, and corporate functions. We entered into a ground lease
for this facility that extends through March 31, 2069, subject to renewal and
purchase options as well as early termination provisions. Costs to initially
construct, furnish, and equip the Tempe facility were approximately $24.0
million.

We lease approximately 7,035 square feet of space in Boulder, Colorado,
where we maintain a business unit focusing on personal microdisplay systems and
comprised of former Zight Corporation employees.

We lease approximately 3,500 square feet of office and warehouse space in
Swindon, United Kingdom, where we maintain our European administrative offices
and a distribution warehouse.

We lease an approximately 65,000 square foot manufacturing facility in
Carmelray Industrial Park, Barangay Tulo, Calamba, Laguna, the Philippines with
an option to purchase the premises. The lease expires in 2010.

We occupy approximately 16,500 square feet of manufacturing space in
Manila, the Philippines, at the TEAM facility. We have a sub-assembly
agreement with TEAM with respect to operations at that facility. We expect to
vacate that property and terminate the sub-assembly agreement in the second
quarter of 2002.

We own and occupy a 46,000 square foot facility in Beijing, China,
including 29,000 square feet of manufacturing space. We constructed this
facility on property that we have purchased on a long-term land use contract.
Costs to construct, furnish, and equip the Beijing facility were approximately
$10.9 million.




ITEM 3.    LEGAL PROCEEDINGS

There are no legal proceedings to which we are a party or to which any of
our properties are subject, other than routine litigation incident to our
business that is covered by insurance or an indemnity or that we do not expect
to have a material adverse effect on our company. It is possible, however,
that we could incur claims for which we are not insured or that exceed the
amount of our insurance coverage.




ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

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##### Table of Contents






PART II




ITEM 5.    MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock has been listed on the New York Stock Exchange under the
symbol TFS since December 29, 1994. The following table sets forth the
quarterly high and low sales prices of our common stock as reported on the New
York Stock Exchange for the periods indicated, adjusted to reflect the
four-for-three split of our common stock effected in December 1999 and the
three-for-two split of our common stock effected in May 2000.

|      |                                        |  |      |       |     |  |   |       | 
|----- | -------------------------------------- |  | ---- | ----- | --- |  | - | ----- | 
|      |                                        |  | High |       | Low
|      |                                        |  |      |       |    
|1999: |                                        |  |      |       |     |  |   |      
|     
|     
|     
|     
|      | First Quarter                          |  | $    | 8.00  |     |  | $ | 4.31  | 
|     
|     
|     
|     
|      | Second Quarter                         |  |      | 6.91  |     |  |   | 4.03  | 
|     
|     
|     
|     
|      | Third Quarter                          |  |      | 11.06 |     |  |   | 6.84  | 
|     
|     
|     
|     
|      | Fourth Quarter                         |  |      | 27.33 |     |  |   | 11.13 | 
|     
|     
|     
|     
|      |                                        |  |      |       |     |  |   |      
|     
|     
|     
|     
|2000: |                                        |  |      |       |     |  |   |      
|     
|     
|     
|     
|      | First Quarter                          |  | $    | 43.71 |     |  | $ | 25.46 | 
|     
|     
|     
|     
|      | Second Quarter                         |  |      | 80.75 |     |  |   | 36.75 | 
|     
|     
|     
|     
|      | Third Quarter                          |  |      | 67.25 |     |  |   | 24.00 | 
|     
|     
|     
|     
|      | Fourth Quarter                         |  |      | 39.06 |     |  |   | 16.44 | 
|     
|     
|     
|     
|      |                                        |  |      |       |     |  |   |      
|     
|     
|     
|     
|2001: |                                        |  |      |       |     |  |   |      
|     
|     
|     
|     
|      | First Quarter                          |  | $    | 27.11 |     |  | $ | 11.74 | 
|     
|     
|     
|     
|      | Second Quarter                         |  |      | 18.35 |     |  |   | 10.68 | 
|     
|     
|     
|     
|      | Third Quarter                          |  |      | 23.85 |     |  |   | 14.18 | 
|     
|     
|     
|     
|      | Fourth Quarter                         |  |      | 21.74 |     |  |   | 14.60 | 
|     
|     
|     
|     
|      |                                        |  |      |       |     |  |   |      
|     
|     
|     
|     
|2002: |                                        |  |      |       |     |  |   |      
|     
|     
|     
|     
|      | First Quarter (through March 11, 2002) |  | $    | 17.80 |     |  | $ | 12.19 | 

As of March 11, 2002, there were approximately 687 holders of record of
our common stock. The closing sale price of our common stock on the New York
Stock Exchange on March 11, 2002 was $14.06 per share.

Our policy is to retain earnings to provide funds for the operation and
expansion of our business. We have not paid cash dividends on our common stock
and do not anticipate that we will do so in the foreseeable future.
Furthermore, our credit facility with Comerica Bank does not permit us to pay
dividends without the consent of Comerica Bank. The payment of dividends in
the future will depend on our growth, profitability, financial condition, and
other factors that our board of directors may deem relevant.




ITEM 6.    SELECTED FINANCIAL DATA

The selected historical financial data presented below are derived from
our consolidated financial statements, which have been audited by Arthur
Andersen LLP, independent public accountants. The selected financial data
should be read in conjunction with Item 7, Managements Discussion and
Analysis of Financial Condition and Results of Operations and the Consolidated
Financial Statements and the Notes thereto included elsewhere in this report.
All share amounts and per share data have been adjusted to reflect the
four-for-three split of our common stock effected in December 1999 and the
three-for-two split of our common stock effected in May 2000.

26



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##### Table of Contents



|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |         |        |  
|---------------------------------------------------- | -------------------------------------- | ------- | ------ | ------------------------------------- | ------ | ---- | ------ | ------ | ------ | ---- | ------- | ------- | ------ | - | ------- | ------- | ------ | - | ------- | ------- | ------ | -
|                                                     |                                        |         |        | Years Ended December 31,             
|                                                     |                                        |         |        |                                      
|                                                     |                                        |         |        | 1997                                  |        | 1998 |        | 1999   |        | 2000 |         | 2001   
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |        
|                                                     |                                        |         |        | (in thousands, except per share data)
|Consolidated Statement of Operations Data:           |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                    
|                                                    
|                                                    
|                                                    
|Net sales                                            |                                        | $       | 84,642 |                                       |        | $    | 95,047 |        |        | $    | 147,408 |         |        | $ | 160,684 |         |        | $ | 119,136 |        
|                                                    
|                                                    
|                                                    
|                                                    
|Costs and expenses:                                  |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Cost of sales                          |         |        | 64,760                                |        |      |        | 76,149 |        |      |         | 117,583 |        |   |         | 124,724 |        |   |         | 121,514 |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Selling, general, and administrative   |         |        | 6,557                                 |        |      |        | 7,334  |        |      |         | 11,170  |        |   |         | 9,501   |        |   |         | 10,130  |       
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Research, development, and engineering |         |        | 5,106                                 |        |      |        | 7,159  |        |      |         | 8,745   |        |   |         | 13,295  |        |   |         | 17,618  |       
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                     |                                        |         | 76,423 |                                       |        |      | 90,642 |        |        |      | 137,498 |         |        |   | 147,520 |         |        |   | 149,262 |        
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|Operating income (loss)                              |                                        |         | 8,219  |                                       |        |      | 4,405  |        |        |      | 9,910   |         |        |   | 13,164  |         |        |   | (30,126 | )      
|                                                    
|                                                    
|                                                    
|                                                    
|Other income (expense), net                          |                                        |         | 358    |                                       |        |      | (42    | )      |        |      | (18     | )       |        |   | 7,184   |         |        |   | 3,450   |        
|                                                    
|                                                    
|                                                    
|                                                    
|Minority interest in loss of consolidated subsidiary |                                        |         |       |                                       |        |      |       |        |        |      |        |         |        |   |        |         |        |   | 167     |        
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                    
|                                                    
|                                                    
|                                                    
|Income (loss) before income taxes                    |                                        |         | 8,577  |                                       |        |      | 4,363  |        |        |      | 9,892   |         |        |   | 20,348  |         |        |   | (26,509 | )      
|                                                    
|                                                    
|                                                    
|                                                    
|Provision for (benefit from) income taxes            |                                        |         | 3,334  |                                       |        |      | 1,773  |        |        |      | 2,968   |         |        |   | 5,514   |         |        |   | (8,745  | )      
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|Net income (loss)                                    |                                        | $       | 5,243  |                                       |        | $    | 2,590  |        |        | $    | 6,924   |         |        | $ | 14,834  |         |        | $ | (17,764 | )      
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|Earnings (loss) per common share:                    |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                        | Basic   |        | $                                     | 0.33   |      |        | $      | 0.17   |      |         | $       | 0.44   |   |         | $       | 0.73   |   |         | $       | (0.83  | )
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                     |                                        | Diluted |        | $                                     | 0.32   |      |        | $      | 0.17   |      |         | $       | 0.43   |   |         | $       | 0.69   |   |         | $       | (0.83  | )
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|Weighted average number of common shares:            |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     |                                        | Basic   |        |                                       | 15,708 |      |        |        | 15,277 |      |         |         | 15,563 |   |         |         | 20,457 |   |         |         | 21,401 |  
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        
|                                                     |                                        | Diluted |        |                                       | 16,180 |      |        |        | 15,604 |      |         |         | 16,005 |   |         |         | 21,365 |   |         |         | 21,401 |  
|                                                     |                                        |         |        |                                       |        |      |        |        |        |      |         |         |        |   |         |         |        |   |         |        

|                                                      |  |                |        |      |  |      |        |      |  |      |         |  |  |   |         |  |  |   |         | 
|----------------------------------------------------- |  | -------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | ------- |  |  | - | ------- |  |  | - | ------- | 
|                                                      |  | December 31,  
|                                                      |  |               
|                                                      |  | 1997           |        | 1998 |  | 1999 |        | 2000 |  | 2001
|                                                      |  |                |        |      |  |      |        |      |  |     
|                                                      |  | (in thousands)
|Consolidated Balance Sheet Data:                      |  |                |        |      |  |      |        |      |  |      |         |  |  |   |         |  |  |   |         | 
|                                                     
|                                                     
|                                                     
|                                                     
|                                                      |  |                |        |      |  |      |        |      |  |      |         |  |  |   |         |  |  |   |         | 
|                                                     
|                                                     
|                                                     
|                                                     
|Working capital                                       |  | $              | 29,113 |      |  | $    | 24,825 |      |  | $    | 60,853  |  |  | $ | 194,492 |  |  | $ | 169,123 | 
|                                                     
|                                                     
|                                                     
|                                                     
|Total assets                                          |  |                | 72,835 |      |  |      | 77,904 |      |  |      | 126,930 |  |  |   | 267,843 |  |  |   | 245,888 | 
|                                                     
|                                                     
|                                                     
|                                                     
|Notes payable to banks, term loans
and long-term debt |  |                |       |      |  |      | 8,095  |      |  |      |        |  |  |   | 2,706   |  |  |   | 2,706   | 
|                                                     
|                                                     
|                                                     
|                                                     
|Stockholders equity                                  |  |                | 56,525 |      |  |      | 51,096 |      |  |      | 101,220 |  |  |   | 242,002 |  |  |   | 223,944 | 




ITEM 7.    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS AND FACTORS THAT MAY AFFECT RESULTS

In addition to the historical information contained herein, this Report
contains forward-looking statements, including those relating to revenue,
earnings margins, pricing pressures, quarterly fluctuations, the impact of
moving our Arizona LCD line, material shortages, research, development, and
engineering expense, selling, general and administrative expenses, and
liquidity and anticipated cash needs that involve risks and uncertainties that
could cause actual results to differ materially.

We caution that these statements are qualified by various factors that may
affect future results, including the Special Considerations in Item 1.

27



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##### Table of Contents



Overview

We offer advanced design and manufacturing services to original equipment
manufacturers, commonly referred to as OEMs. We specialize in custom display
modules utilizing liquid crystal display, or LCD, components and technology.
Our LCD modules have varying levels of integration. At a minimum, each module
includes an LCD, a custom LCD driver, and a flexible connector. We also
provide value-added services, which increase our competitiveness, by assembling
additional components onto the module based upon the specific needs of the
customer. These additional components may include such items as keypads,
microphones, speakers, light guides, and optics.

We currently sell substantially all of our LCD modules to major OEMs. We
derived more than 80% of our net sales in 1999, 2000, and 2001 from the mobile
handset market. When we win a design program, our customers sometimes pay all
or a portion of our nonrecurring engineering expenses to defray the costs of
custom design, as well as all or a portion of the costs of nonrecurring tooling
for custom components. The typical design program life cycle of a
custom-designed LCD module is three to fifteen months and includes technical
design, prototyping, pilot manufacturing, and high-volume manufacturing. In
2001, our strategy was to seek large volume programs from major OEMs. In that
situation, the minimum production quantity for an LCD module typically
approximates 100,000 units per year, although the production rate for some
programs has been higher than 100,000 units per week. Recently, we have
re-focused our strategy on lower volume programs with potentially higher gross
margins. We have re-focused our strategy because some OEMs with high-volume
programs have begun to expect to purchase LCD modules for less than industry
costs. The selling price of our LCD modules usually ranges between $3 and $50
per unit. We recognize revenue when persuasive evidence of an arrangement
exists, delivery has occurred, the fee is fixed or determinable, and
collectability is probable. Generally, all of these conditions are met at the
time we ship products to customers.

We experienced substantial growth from 1993 through 1995, primarily as a
result of sales to OEMs in the wireless communications industry, which grew
substantially during that period. During that period, our primary customer was
Motorola. In 1996, our net sales declined, primarily as a result of the
phase-out by Motorola of a significant family of programs. In 1997, our net
sales returned to pre-1996 levels primarily as a result of several new programs
and customers. We experienced substantial growth again in 1999 and 2000, but
due to the world-wide economic slowdown in 2001, our sales substantially
declined. Motorola and its subcontractors accounted for 34.6% of our net sales
in 1997, 63.6% in 1998, 86.1% in 1999, 86.9% in 2000, and 85.4% in 2001.

During the past several years, we have experienced seasonal quarterly
fluctuations in our net sales as our OEM customers developed retail products
with shorter product life cycles and phased out older programs early in the
year following holiday sales. As a result, sales usually peak in the fourth
quarter of a calendar year and are lower in the following quarter. This
pattern did not occur in the fourth quarter of 2000 and the first quarter of
2001 as a result of supply interruptions in the fourth quarter and reduced
expectations in the mobile handset market, but this pattern is expected to
occur in the fourth quarter of 2001 and the first quarter of 2002.

Several factors impact our gross margins, including manufacturing
efficiencies, product mix, product differentiation, product uniqueness,
inventory management, and volume pricing. In addition, significant pricing
pressure exists in the LCD module market. Accordingly, those factors have
impacted, and will continue to impact, our overall margins.

We vertically integrate our manufacturing facilities. We generally have
used our own high-volume LCD production line for the manufacture of more
technologically complex and custom high-volume LCDs. We also purchased LCDs
from third-party sources to provide us an alternate source and to ensure
available capacity. In order to take advantage of lower labor costs, we have
traditionally shipped LCDs to our facilities in Manila, the Philippines, or
Beijing, China, for assembly into modules.

During the second quarter of 2001, we announced our strategic decision to
move our front-end, high-volume LCD line from Arizona to Asia. The LCD line
was operated in Arizona through the third quarter of 2001, but the line is now
shut down and in transit to Asia. We expect it will take two to three quarters
to re-install the line in Asia. We expect to incur no interruption in our LCD
module production, as we will rely on built inventory stock and third-party
sources during the period that the line is being moved.

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##### Table of Contents



In Manila, we assemble LCDs into modules and perform certain
back-end LCD processing operations. Our back-end LCD processing operations
have been and will continue to be conducted in Manila through a third-party
subcontract manufacturer through April 2002. After April 2002, the Manila
back-end LCD processing will be performed in our facility. The subcontractor
supplies direct labor and incidental services required to manufacture our
products. All indirect manufacturing employees, primarily technicians,
supervisors, and engineers, are our employees. Our LCD module operations are
conducted at our own factory, where we employ our own employees and do not
employ the services of a third-party subcontractor.

In Beijing, we also assemble LCDs into modules. Our LCD module operations
in Beijing are conducted at a facility we own through a wholly owned foreign
subsidiary. We employ our own employees in Beijing.

Selling, general, and administrative expense consists principally of
administrative and selling costs, salaries, commissions, and benefits to
personnel and related facility costs. We make substantially all of our sales
directly to OEMs, and our sales force consists of a small number of direct
technical sales persons. As a result, there is no material cost of
distribution in our selling, general, and administrative expense. In addition,
we have recently incurred substantial marketing and administrative expenses in
connection with our LCoSmicrodisplay business.

Research, development, and engineering expense consists principally of
salaries and benefits to scientists, design engineers, and other technical
personnel, related facility costs, process development costs, and various
expenses for projects, including new product development. Research,
development, and engineering expense continues to increase as we develop new
display products and technologies, especially LCoSmicrodisplays.

Since 1997, we have been working on the development of LCoSmicrodisplays.
In 1997, we entered into a strategic alliance with National Semiconductor
Corporation for the development of LCoSmicrodisplay products. Under that
alliance, National focused on the silicon technologies needed for
microdisplays, and we focused on the liquid crystal technologies. In 1999,
National decided to close its microdisplay business unit. In connection with
that closing, in July 1999, we purchased certain assets and licensed silicon
technologies from National relating to LCoSmicrodisplays. We paid
approximately $3.0 million in cash and issued warrants to purchase 140,000
shares of our common stock in the transaction, which valued the transaction at
approximately $3.6 million. No additional payments are required under the
licenses. We also hired several key technical employees of National to assist
in the implementation of the acquired technologies.

In April 1998, we entered into a strategic relationship with Inviso, Inc.,
a privately held company with numerous patents and proprietary technology
related to microdisplay development. We acquired a minority equity interest in
Inviso for approximately $3.3 million. In March 2000, we acquired an
additional interest in Inviso for $500,000, raising our total minority equity
interest to $3.8 million. As part of this strategic relationship, we provided
proprietary manufacturing capabilities and liquid crystal expertise, and Inviso
provided patented and proprietary technologies and components for the joint
development of microdisplay products. In the second quarter of 2001, we wrote
off our investment of $3.8 million in Inviso because we determined that our
investment was impaired, as that term is defined under generally accepted
accounting principles. Subsequent to our write-off, Inviso was unable to
raise funds to operate its business and has since ceased operations.

In August 2000, our wholly owned subsidiary, Three-Five Systems (Beijing)
Co., Ltd., entered into a strategic agreement with Heibei Jiya Electronics,
Co., Ltd. (Jiya), a Chinese-based manufacturer of LCD glass. Under the terms
of the agreement, Jiya agreed to provide LCD glass to us and reserve a
significant amount of LCD glass manufacturing capacity for us. In exchange, we
agreed to assist Jiya in further developing its LCD glass manufacturing
processes. At the conclusion in February 2002, we had the option to extend the
agreement or to acquire a majority interest in Jiya. We elected not to extend
the agreement or acquire a majority interest.

In 2001, we invested $1.25 million in Silicon Bandwidth, Inc., a privately
held company providing unique semiconductor and optoelectronic interconnect
solutions based upon multiple, patented, proprietary technologies. We are
working closely with Silicon Bandwidth to design unique, cost-effective,
reconfigurable packaging platforms for LCoSmicrodisplays.

During the second quarter of 2001, we formed a new company, Three-D OLED
L.L.C., with DuPont Displays, a business unit of DuPont Corporation. We own 51%
of this new venture, and DuPont Displays owns 49%. The companies have pledged
$3.0 million to the venture. Our share of that obligation is slightly over
$1.5

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million. This new venture was formed to design, assemble, and market OLED
(Organic Light Emitting Diode) display modules to OEMs worldwide. The venture
focuses on glass substrate, passive matrix OLED displays. OLED technology
utilizes advanced materials to produce bright, high-contrast, emissive
displays. The venture is headquartered in Tempe, Arizona, within our existing
corporate headquarters, and is controlled by us. The venture will utilize the
glass panel output of a planned high-volume manufacturing plant located in
Taiwan, announced by DuPont and RiTdisplay Technology Corporation. The venture
may also use other OLED glass panel sources. OLED display modules will be
assembled at our display module assembly facilities in Beijing and Manila.

In January 2002, we purchased the intellectual property of Zight
Corporation, a private company focused on microdisplays for personal display
system applications. In addition, we purchased certain key assets of Zight at
a creditors auction and we hired six key technical persons formerly employed
by Zight. The total cost of the acquisition was approximately $2.6 million.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of
operations are based upon our financial statements, which have been prepared in
accordance with generally accepted accounting principles (GAAP) of the United
States of America. During preparation of these financial statements, we are
required to make estimates and judgements that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosure of
contingent assets and liabilities. On an on-going basis, we evaluate our
estimates, including those related to product returns, bad debts, inventories,
investments, fixed assets, intangible assets, income taxes, pensions and other
post-retirement benefits, contingencies and litigation. We base our estimates
on historical experience and on various other assumptions that we believe are
reasonable under the circumstances. The results form the basis for making
judgements about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more
significant judgements and estimates used in the preparation of our financial
statements.

We recognize sales when persuasive evidence of a sale exists, that is, a
product is shipped under an agreement with a customer, risk of loss and title
have passed to the customer, the fee is fixed or determinable, and collection
of the resulting receivable is reasonably assured.

We maintain an allowance for doubtful accounts for estimated losses
resulting from the inability of our customers to make required payments. We
determine the adequacy of this allowance by regularly evaluating individual
customer receivables, considering a customers financial condition, credit
history and current economic conditions. If the financial condition of our
customers were to deteriorate, additional allowances may be required.

We write down our inventory for estimated obsolescence or unmarketable
inventory equal to the difference between the cost of inventory and the
estimated market value based upon assumptions about future demand and market
conditions. If actual market conditions are less favorable than those projected
by management, additional inventory write-downs may be required.

We estimate our actual current tax exposure together with the temporary
differences that have resulted from the differing treatment of items dictated
by generally accepted accounting principles versus US tax laws. These temporary
differences result in deferred tax assets and liabilities. On an on-going
basis, we then assess the likelihood that our deferred tax assets will be
recovered from future taxable income. If we were to believe that the recovery
were not more likely than not, we would establish a valuation allowance against
the deferred tax asset and charge the amount as an income tax expense in the
period in which such a determination were made.

Results of Operations

The following table sets forth, for the periods indicated, the percentage
of net sales of certain items in our Consolidated Financial Statements.

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|                                                     |                                        |  |                          |      |      |  |       |      |  |  |       |       | 
|---------------------------------------------------- | -------------------------------------- |  | ------------------------ | ---- | ---- |  | ----- | ---- |  |  | ----- | ----- | 
|                                                     |                                        |  | Years Ended December 31,
|                                                     |                                        |  |                         
|                                                     |                                        |  | 1999                     |      | 2000 |  | 2001 
|                                                     |                                        |  |                          |      |      |  |      
|Net sales                                            |                                        |  | 100.0                    | %    |      |  | 100.0 | %    |  |  | 100.0 | %    
|                                                     |                                        |  |                          |      |      |  |       |      |  |  |       |      
|Costs and expenses:                                  |                                        |  |                          |      |      |  |       |      |  |  |       |      
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Cost of sales                          |  |                          | 79.8 |      |  |       | 77.6 |  |  |       | 102.0 | 
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Selling, general, and administrative   |  |                          | 7.6  |      |  |       | 5.9  |  |  |       | 8.5   | 
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Research, development, and engineering |  |                          | 5.9  |      |  |       | 8.3  |  |  |       | 14.8  | 
|                                                     |                                        |  |                          |      |      |  |       |      |  |  |       |      
|                                                     |                                        |  | 93.3                     |      |      |  | 91.8  |      |  |  | 125.3 |      
|                                                     |                                        |  |                          |      |      |  |       |      |  |  |       |      
|Operating income (loss)                              |                                        |  | 6.7                      |      |      |  | 8.2   |      |  |  | (25.3 | )    
|                                                    
|                                                    
|                                                    
|                                                    
|Other income, net                                    |                                        |  |                         |      |      |  | 4.5   |      |  |  | 2.9   |      
|                                                    
|                                                    
|                                                    
|                                                    
|Minority interest in loss of consolidated
subsidiary |                                        |  |                         |      |      |  |      |      |  |  | 0.1   |      
|                                                     |                                        |  |                          |      |      |  |       |      |  |  |       |      
|Income (loss) before income taxes                    |                                        |  | 6.7                      |      |      |  | 12.7  |      |  |  | (22.3 | )    
|                                                    
|                                                    
|                                                    
|                                                    
|Provision for (benefit from) income taxes            |                                        |  | 2.0                      |      |      |  | 3.5   |      |  |  | (7.4  | )    
|                                                     |                                        |  |                          |      |      |  |       |      |  |  |       |      
|Net income (loss)                                    |                                        |  | 4.7                      | %    |      |  | 9.2   | %    |  |  | (14.9 | )%   
|                                                     |                                        |  |                          |      |      |  |       |      |  |  |       |      

Year ended December 31, 2001 compared to year ended December 31, 2000

Net Sales.Net sales decreased 25.9% to $119.1 million in 2001 from
$160.7 million in 2000. Although some of the decrease was attributable to the
reduced volume of unit shipments, the revenue decrease was primarily the result
of decreased selling prices of LCD modules due to excess worldwide LCD
capacity. We shipped 13.0 million units in 2001 versus 14.9 million units in
2000.

Cost of Sales.Cost of sales increased to 102.0% of net sales in 2001
from 77.6% in 2000. This percentage increase resulted primarily from reduced
selling prices and reduced operating efficiencies. Also contributing to the
increased cost of sales was the sale of LCoSmicrodisplay products at a loss.
We incurred a loss at the gross margin line for our LCoSmicrodisplay sales
primarily because of very low manufacturing yields.

Selling, General, and Administrative Expense.Selling, general, and
administrative expense increased 6.3% to $10.1 million in 2001 from $9.5
million in 2000. Selling, general, and administrative expense was 8.5% of net
sales in 2001 compared to 5.9% of net sales in 2000. This increase in percent
was due to lower net sales in 2001.

Research, Development, and Engineering Expense.Research, development,
and engineering expense increased 32.3% to $17.6 million in 2001 from $13.3
million in 2000. Research, development, and engineering expense was 14.8% of
net sales in 2001 compared to 8.3% of net sales in 2000. Research,
development, and engineering expense overall increased as the result of the
continued development of LCoSmicrodisplays.

The selling, general, and administrative expense and the research,
development, and engineering expense in each year included significant
operating expenditures in LCoSmicrodisplays at a time when there was very
little LCoSmicrodisplay revenue. In 2001, we incurred approximately $13.5
million of operating expenses specifically related to LCoSmicrodisplays
compared to approximately $9.4 million in 2000.

Other Income (Expense), Net.Other income in 2001 was $3.4 million
compared to other income of $7.2 million in 2000. The primary difference was
the write-off of our $3.8 million investment in Inviso, Inc. Interest earned
in 2001 was $7.3 million compared with $7.4 million in 2000.

Provision for (Benefit from) Income Taxes.We recorded a benefit from
income taxes of $8.7 million in 2001 compared to a provision for income taxes
of $5.5 million in 2000. In recording the benefit, we used an effective tax
rate of 33.0% in 2001 compared to an effective tax rate of 27.1% in 2000. The
difference is primarily a change in relative operational results between U.S.
and foreign jurisdictions, and a benefit for research and development credits
recorded during 2000. In 2002, we expect to record a tax benefit against any
operating losses we incur using an estimated rate of approximately 33%. The
benefit for income taxes that we recorded has generated a $5.2 million deferred
tax asset at December 31, 2001 related to net operating loss and tax credit
carryforwards of which no valuation allowance has been recorded as management
believes it is more likely than not that these deferred tax assets will be
fully realized.

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Net Income.In 2001, we recorded a net loss of $17.8 million using
generally accepted accounting principles, or $0.83 per diluted share compared
to net income of $14.8 million, or $0.69 per diluted share, in 2000. We
recorded several unusual expense items in the second quarter of 2001, including
the write-off of our investment in Inviso, Inc., the write-off of certain
inventory, and the write-off of an Enterprise Resource Planning system
implementation. On an after-tax basis, those unusual expenses totaled $5.1
million, or $0.24 per diluted share. The direct view display segment recorded
a net loss of $3.7 million, or $0.17 loss per diluted share in 2001 compared to
net income of $20.9 million, or $0.97 earnings per share in 2000. The decline
in revenue was related to intense pricing pressures for our modules and the
worldwide economic slowdown in 2001. The microdisplay segment recorded a net
loss of $14.1 million, or $0.66 per diluted share in 2001 compared to a net
loss of $6.1 million, or $0.28 per diluted share in 2000. The increased loss
was created by intensified RD&E efforts to bring microdisplays to market.

Year ended December 31, 2000 compared to year ended December 31, 1999

Net Sales.Net sales increased 9.0% to $160.7 million in 2000 from $147.4
million in 1999. This increase was the result of several new programs,
primarily for Motorola.

Cost of Sales.Cost of sales decreased to 77.6% of net sales in 2000 from
79.8% in 1999. This percentage decrease resulted primarily from increased
operating efficiencies in the first half of 2000 and cost reduction efforts.
Pricing pressures and under-absorption issues resulting from decreased
production levels in the second half of 2000 actually resulted in a sharp
increase in the cost of sales in the second half of 2000, especially in the
fourth quarter.

Selling, General, and Administrative Expense.Selling, general, and
administrative expense decreased 15.2% to $9.5 million in 2000 from $11.2
million in 1999. Selling, general, and administrative expense was 5.9% of net
sales in 2000 compared to 7.6% in 1999. The decrease in selling, general, and
administrative expense was a result of our efforts to hold down costs.

Research, Development, and Engineering Expense.Research, development,
and engineering expense increased 52.9% to $13.3 million in 2000 from $8.7
million in 1999. Research, development, and engineering expense was 8.3% of
net sales in 2000 compared to 5.9% in 1999. In general, research, development,
and engineering expense overall increased as the result of the development of
new display products and technologies, including LCoSmicrodisplays. Expenses
also increased in LCD engineering as a result of the increased number of design
wins.

The selling, general, and administrative expense and the research,
development, and engineering expense in each year included significant
operating expenditures in LCoSmicrodisplays at a time when there was very
little LCoSmicrodisplay revenue. In 2000, we incurred approximately $9.4
million of operating expenses specifically related to LCoSmicrodisplays
compared to approximately $6.6 million in 1999.

Other Income (Expense), Net.Other income in 2000 was $7.2 million
compared to other expense of $18,000 in 1999. We had sharply higher interest
income and reduced interest expense in 2000 as the result of decreased debt and
increased cash and investment balances. Those increased cash and investment
balances were primarily as a result of our equity offering in May 2000.

Provision for Income Taxes.We recorded a provision for income taxes of
$5.5 million in 2000 compared to $3.0 million in 1999. The effective tax rate
was 27.1% in 2000 compared to 30.0% in 1999. This change resulted primarily
from tax benefits in the third and fourth quarters of 2000 relating to research
and development tax credits. Generally, the tax rate was also lower in 2000 as
a result of higher net income in China, which is a low tax rate jurisdiction.
In 2001, we expect our overall tax rate to be approximately 33.0%.

Net Income.Net income increased 114.5% to $14.8 million, or $0.69 per
diluted share, in 2000 from $6.9 million, or $0.43 per diluted share, in 1999.
The direct view display segment recorded net income of $20.9 million, or $0.97
earnings per share in 2000 compared to net income of $11.4 million, or $0.71
earnings per share in 1999. The microdisplay segment recorded a net loss of
$6.1 million, or $0.28 loss per share in 2000 compared to a net loss of $4.5
million, or $0.28 loss per share in 1999.

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Quarterly Results of Operations

The following table presents unaudited consolidated statement of
operations data for each of the eight quarters in the period ended December 31,
2001, as well as such data expressed as a percentage of net sales. We believe
that all necessary adjustments have been included to present fairly the
quarterly information when read in conjunction with the Consolidated Financial
Statements. The operating results for any quarter are not necessarily
indicative of the results for any subsequent quarter.

|                                             |                                        |   |                |        |         |   |          |        |         |   |         |        |         |   |          |        |         |   |        |        |  |   |         |        |  |   |        |        |  |   |        |        | 
|-------------------------------------------- | -------------------------------------- | - | -------------- | ------ | ------- | - | -------- | ------ | ------- | - | ------- | ------ | ------- | - | -------- | ------ | ------- | - | ------ | ------ |  | - | ------- | ------ |  | - | ------ | ------ |  | - | ------ | ------ | 
|                                             |                                        |   | Quarters Ended
|                                             |                                        |   | (in thousands)
|                                             |                                        |   | 2000           |        | 2001   
|                                             |                                        |   |                |        |        
|                                             |                                        |   | Mar. 31        |        | June 30 |   | Sept. 30 |        | Dec. 31 |   | Mar. 31 |        | June 30 |   | Sept. 30 |        | Dec. 31
|                                             |                                        |   |                |        |         |   |          |        |         |   |         |        |         |   |          |        |        
|Net sales                                    |                                        | $ | 39,162         |        |         | $ | 44,926   |        |         | $ | 40,231  |        |         | $ | 36,365   |        |         | $ | 35,616 |        |  | $ | 25,013  |        |  | $ | 26,594 |        |  | $ | 31,913 |       
|                                             |                                        |   |                |        |         |   |          |        |         |   |         |        |         |   |          |        |         |   |        |        |  |   |         |        |  |   |        |        |  |   |        |       
|Cost and expenses:                           |                                        |   |                |        |         |   |          |        |         |   |         |        |         |   |          |        |         |   |        |        |  |   |         |        |  |   |        |        |  |   |        |       
|                                            
|                                            
|                                            
|                                            
|                                             | Cost of sales                          |   |                | 29,360 |         |   |          | 34,157 |         |   |         | 31,115 |         |   |          | 30,092 |         |   |        | 31,243 |  |   |         | 32,160 |  |   |        | 27,453 |  |   |        | 30,658 | 
|                                            
|                                            
|                                            
|                                            
|                                             | Selling, general, and
administrative   |   |                | 2,262  |         |   |          | 2,418  |         |   |         | 2,453  |         |   |          | 2,368  |         |   |        | 2,491  |  |   |         | 2,922  |  |   |        | 2,444  |  |   |        | 2,273  | 
|                                            
|                                            
|                                            
|                                            
|                                             | Research, development,
and engineering |   |                | 2,763  |         |   |          | 2,989  |         |   |         | 3,734  |         |   |          | 3,809  |         |   |        | 3,661  |  |   |         | 4,795  |  |   |        | 4,224  |  |   |        | 4,938  | 
|                                             |                                        |   |                |        |         |   |          |        |         |   |         |        |         |   |          |        |         |   |        |        |  |   |         |        |  |   |        |        |  |   |        |       
|                                             |                                        |   | 34,385         |        |         |   | 39,564   |        |         |   | 37,302  |        |         |   | 36,269   |        |         |   | 37,395 |        |  |   | 39,877  |        |  |   | 34,121 |        |  |   | 37,869 |       
|                                             |                                        |   |                |        |         |   |          |        |         |   |         |        |         |   |          |        |         |   |        |        |  |   |         |        |  |   |        |        |  |   |        |       
|Operating income (loss)                      |                                        |   | 4,777          |        |         |   | 5,362    |        |         |   | 2,929   |        |         |   | 96       |        |         |   | (1,779 | )      |  |   | (14,864 | )      |  |   | (7,527 | )      |  |   | (5,956 | )     
|                                            
|                                            
|                                            
|                                            
|Other income (expense), net                  |                                        |   | 580            |        |         |   | 1,165    |        |         |   | 2,736   |        |         |   | 2,703    |        |         |   | 2,140  |        |  |   | (2,073  | )      |  |   | 1,497  |        |  |   | 1,886  |       
|                                            
|                                            
|                                            
|                                            
|Minority interest in
consolidated
subsidiary |                                        |   |               |        |         |   |         |        |         |   |        |        |         |   |         |        |         |   |       |        |  |   |        |        |  |   | 62     |        |  |   | 105    |       
|                                             |                                        |   |                |        |         |   |          |        |         |   |         |        |         |   |          |        |         |   |        |        |  |   |         |        |  |   |        |        |  |   |        |       
|Income (loss) before
income taxes            |                                        |   | 5,357          |        |         |   | 6,527    |        |         |   | 5,665   |        |         |   | 2,799    |        |         |   | 361    |        |  |   | (16,937 | )      |  |   | (5,968 | )      |  |   | (3,965 | )     
|                                            
|                                            
|                                            
|                                            
|Provision for (benefit
from) income taxes    |                                        |   | 1,770          |        |         |   | 2,158    |        |         |   | 1,320   |        |         |   | 266      |        |         |   | 119    |        |  |   | (5,589  | )      |  |   | (1,972 | )      |  |   | (1,303 | )     
|                                             |                                        |   |                |        |         |   |          |        |         |   |         |        |         |   |          |        |         |   |        |        |  |   |         |        |  |   |        |        |  |   |        |       
|Net income (loss)                            |                                        | $ | 3,587          |        |         | $ | 4,369    |        |         | $ | 4,345   |        |         | $ | 2,533    |        |         | $ | 242    |        |  | $ | (11,348 | )      |  | $ | (3,996 | )      |  | $ | (2,662 | )     
|                                             |                                        |   |                |        |         |   |          |        |         |   |         |        |         |   |          |        |         |   |        |        |  |   |         |        |  |   |        |        |  |   |        |       

|                                             |                                        |  |                         |      |         |  |          |      |         |  |         |      |         |  |          |      |         |  |       |      |  |  |        |       |  |  |        |       |  |  |        |      | 
|-------------------------------------------- | -------------------------------------- |  | ----------------------- | ---- | ------- |  | -------- | ---- | ------- |  | ------- | ---- | ------- |  | -------- | ---- | ------- |  | ----- | ---- |  |  | ------ | ----- |  |  | ------ | ----- |  |  | ------ | ---- | 
|                                             |                                        |  | Percentage of Net Sales
|                                             |                                        |  | Quarters Ended         
|                                             |                                        |  |                        
|                                             |                                        |  | 2000                    |      | 2001   
|                                             |                                        |  |                         |      |        
|                                             |                                        |  | Mar. 31                 |      | June 30 |  | Sept. 30 |      | Dec. 31 |  | Mar. 31 |      | June 30 |  | Sept. 30 |      | Dec. 31
|                                             |                                        |  |                         |      |         |  |          |      |         |  |         |      |         |  |          |      |        
|Net sales                                    |                                        |  | 100.0                   | %    |         |  | 100.0    | %    |         |  | 100.0   | %    |         |  | 100.0    | %    |         |  | 100.0 | %    |  |  | 100.0  | %     |  |  | 100.0  | %     |  |  | 100.0  | %   
|                                             |                                        |  |                         |      |         |  |          |      |         |  |         |      |         |  |          |      |         |  |       |      |  |  |        |       |  |  |        |       |  |  |        |     
|Cost and expenses:                           |                                        |  |                         |      |         |  |          |      |         |  |         |      |         |  |          |      |         |  |       |      |  |  |        |       |  |  |        |       |  |  |        |     
|                                            
|                                            
|                                            
|                                            
|                                             | Cost of sales                          |  |                         | 75.0 |         |  |          | 76.0 |         |  |         | 77.3 |         |  |          | 82.7 |         |  |       | 87.7 |  |  |        | 128.5 |  |  |        | 103.2 |  |  |        | 96.0 | 
|                                            
|                                            
|                                            
|                                            
|                                             | Selling, general, and
administrative   |  |                         | 5.7  |         |  |          | 5.4  |         |  |         | 6.1  |         |  |          | 6.5  |         |  |       | 7.0  |  |  |        | 11.7  |  |  |        | 9.2   |  |  |        | 7.1  | 
|                                            
|                                            
|                                            
|                                            
|                                             | Research, development,
and engineering |  |                         | 7.1  |         |  |          | 6.7  |         |  |         | 9.3  |         |  |          | 10.5 |         |  |       | 10.3 |  |  |        | 19.2  |  |  |        | 15.9  |  |  |        | 15.5 | 
|                                             |                                        |  |                         |      |         |  |          |      |         |  |         |      |         |  |          |      |         |  |       |      |  |  |        |       |  |  |        |       |  |  |        |     
|                                             |                                        |  | 87.8                    |      |         |  | 88.1     |      |         |  | 92.7    |      |         |  | 99.7     |      |         |  | 105.0 |      |  |  | (159.4 | )     |  |  | (128.3 | )     |  |  | (118.6 | )   
|                                             |                                        |  |                         |      |         |  |          |      |         |  |         |      |         |  |          |      |         |  |       |      |  |  |        |       |  |  |        |       |  |  |        |     
|Operating income (loss)                      |                                        |  | 12.2                    |      |         |  | 11.9     |      |         |  | 7.3     |      |         |  | 0.3      |      |         |  | (5.0  | )    |  |  | (59.4  | )     |  |  | (28.3  | )     |  |  | (18.6  | )   
|                                            
|                                            
|                                            
|                                            
|Other income (expense), net                  |                                        |  | 1.5                     |      |         |  | 2.6      |      |         |  | 6.8     |      |         |  | 7.4      |      |         |  | 6.0   |      |  |  | (8.3   | )     |  |  | 5.7    |       |  |  | 5.9    |     
|                                            
|                                            
|                                            
|                                            
|Minority interest in
consolidated
subsidiary |                                        |  |                        |      |         |  |         |      |         |  |        |      |         |  |         |      |         |  |      |      |  |  |       |       |  |  | 0.2    |       |  |  | 0.3    |     
|                                             |                                        |  |                         |      |         |  |          |      |         |  |         |      |         |  |          |      |         |  |       |      |  |  |        |       |  |  |        |       |  |  |        |     
|Income (loss) before
income taxes            |                                        |  | 13.7                    |      |         |  | 14.5     |      |         |  | 14.1    |      |         |  | 7.7      |      |         |  | 1.0   |      |  |  | (67.7  | )     |  |  | (22.4  | )     |  |  | (12.4  | )   
|                                            
|                                            
|                                            
|                                            
|Provision for (benefit
from) income taxes    |                                        |  | 4.5                     |      |         |  | 4.8      |      |         |  | 3.3     |      |         |  | 0.7      |      |         |  | 0.3   |      |  |  | (22.3  | )     |  |  | (7.4   | )     |  |  | (4.1   | )   
|                                             |                                        |  |                         |      |         |  |          |      |         |  |         |      |         |  |          |      |         |  |       |      |  |  |        |       |  |  |        |       |  |  |        |     
|Net income (loss)                            |                                        |  | 9.2                     | %    |         |  | 9.7      | %    |         |  | 10.8    | %    |         |  | 7.0      | %    |         |  | 0.7   | %    |  |  | (45.4  | )%    |  |  | (15.0  | )%    |  |  | (8.3   | )%  
|                                             |                                        |  |                         |      |         |  |          |      |         |  |         |      |         |  |          |      |         |  |       |      |  |  |        |       |  |  |        |       |  |  |        |     

Historically, we have experienced seasonal fluctuations in our net sales.
OEM customers that purchase our products for incorporation into retail
products, such as mobile handsets, typically increase their purchases during
the year-end holiday period and phase out old programs early in the year
following holiday sales. As a result, net sales typically peak in the fourth
quarter and reach a seasonal low point in the first quarter. This pattern did
not occur in 2001 as a result of supply interruptions in the fourth quarter of
2000 and reduced expectations in the mobile handset market. The pattern is
expected to resume for the fourth quarter of 2001 and the first quarter of
2002.

There is significant pricing pressure in higher volume programs in the
wireless communications and office automation industries. This pricing
pressure accelerated in late 2000 and early 2001 as a result of the economic
slowdown in 2001.

33



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##### Table of Contents



As revenue declined in the second half of 2000, absorption issues from the
reduced manufacturing levels resulted in lowered margins. In addition, pricing
pressures in the mobile handset business also contributed to the reduced gross
margins. In 2001, severe pricing pressures in LCD modules as a result of
excess capacity in LCDs resulted in substantially reduced selling prices and,
as a result, in substantially reduced gross margins.

In 2000 and 2001, we continued to expand and intensify our research and
development efforts on proprietary display products, such as LCoS
microdisplays. We had other expense in the second quarter of 2001 as a result
of writing off our Inviso investment.

Liquidity and Capital Resources

At December 31, 2001, we had cash, cash equivalents and short- and
long-term liquid investments of $156.1million compared to $170.1 million at
December 31, 2000.

In 2001, we had $4.1 million in net cash outflow from operations compared
to $6.1 million in net cash flow from operations in 2000. Cash flow from
operations during 2001 decreased as a result of lower revenue. As of December
31, 2001, our inventory turns were 6.7 and DSOs (Day Sales Outstanding) were 64
days as compared with 7.6 inventory turns and 54 DSOs as of December 31, 2000.
Our depreciation and amortization expense was $6.0 million in 2001and 2000.

Our working capital was $169.1 million at December 31, 2001, down from
$194.5 million at December 31, 2000. Our current ratio at December 31, 2001
was 8.8-to-1 compared to 10.1-to-1 at December 31, 2000. The decreases in our
working capital and current ratio occurred primarily because of our net loss
and cash used in operations.

In February 2002, we renewed our credit facility with Comerica Bank. That
credit facility is a $15.0 million unsecured revolving line of credit that
matures in January 2003. No borrowings were outstanding under that credit
facility on December 31, 2001. Advances under the new facility may be made as
prime rate advances, which accrue interest payable monthly at the banks prime
lending rate, or as LIBOR rate advances, which bear interest at 150 basis
points in excess of the LIBOR base rate. As of December 31, 2001, our Beijing
subsidiary had an outstanding $2.7 million term loan due May 8, 2002 to the
Bank of China, which was secured by a $3.0 million stand-by letter of credit
issued by Comerica Bank.

Capital expenditures during 2001 were approximately $8.3 million. Those
capital expenditures consisted of $3.1 million for equipment, leasehold
improvements, intangibles, and license costs in Manila, Beijing, and Arizona,
and $5.2 million for LCoSmicrodisplays. Capital expenditures during 2000 were
approximately $8.8 million. These capital expenditures consisted of $6.4
million for equipment, leasehold improvements, intangibles, and license costs
in Manila, Beijing, and Arizona, and $2.4 million for LCoSmicrodisplays.

The following tables list our contractual obligations and commercial
commitments:

|                                   |  |                        |        |                  |  |           |       |           |  |              |       |  |  |   |       |  |  |   |        | 
|---------------------------------- |  | ---------------------- | ------ | ---------------- |  | --------- | ----- | --------- |  | ------------ | ----- |  |  | - | ----- |  |  | - | ------ | 
|                                   |  | Payments due by Period
|                                   |  |                       
|Contractual Obligations            |  | Total Amounts          |        |                  |  |           |       |           |  |              |       |  |  |   |       |  |  |  
|(in thousands)                     |  | Committed              |        | Less than 1 Year |  | 1-3 Years |       | 4-5 Years |  | Over 5 Years
|Term Loan                          |  | $                      | 2,706  |                  |  | $         | 2,706 |           |  | $            |      |  |  | $ |      |  |  | $ |       | 
|                                  
|                                  
|                                  
|                                  
|Operating Leases                   |  |                        | 15,910 |                  |  |           | 1,125 |           |  |              | 1,969 |  |  |   | 2,080 |  |  |   | 10,736 | 
|                                   |  |                        |        |                  |  |           |       |           |  |              |       |  |  |   |       |  |  |   |        | 
|Total Contractual Cash Obligations |  | $                      | 18,616 |                  |  | $         | 3,831 |           |  | $            | 1,969 |  |  | $ | 2,080 |  |  | $ | 10,736 | 
|                                   |  |                        |        |                  |  |           |       |           |  |              |       |  |  |   |       |  |  |   |        | 

|                             |  |               |     |                  |  |                                            |    |           |  |              |     |  |  |   |     |  |  |  |   | 
|---------------------------- |  | ------------- | --- | ---------------- |  | ------------------------------------------ | -- | --------- |  | ------------ | --- |  |  | - | --- |  |  |  | - | 
|                             |  |               |     |                  |  | Amount of Commitment Expiration Per Period
|Other Commercial Commitments |  | Total Amounts |     |                 
|(in thousands)               |  | Committed     |     | Less than 1 Year |  | 1-3 Years                                  |    | 4-5 Years |  | Over 5 Years
|Guarantee                    |  | $             | 500 |                  |  | $                                          | 94 |           |  | $            | 193 |  |  | $ | 213 |  |  |  |  | 

34



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##### Table of Contents



The operating leases include a lease for our factory in Manila and our
ground lease in Tempe, Arizona. These are described in detail in Note 7 of the
Notes to Consolidated Financial Statements. The guarantee relates to our
guarantee in connection with a Small Business Administration loan given to
VoiceViewer Technology, Inc., a private company developing microdisplay
products. The $3.0 million standby letter of credit issued by Comerica has not
been included in the Other Commercial Commitments table because it only exists
to secure the term loan obligation of $2.7 million, which is already included
in the table for Contractual Obligations. We have no other long-term debt,
capital lease obligations, unconditional purchase obligations or other
long-term obligations and we do not have any other commercial commitments. We
have no off-balance sheet arrangements.

We believe that our existing balances of cash, cash equivalents, and
investments will provide adequate sources to fund our operations and planned
expenditures through 2002, as well as meet our contractual obligations.
Specifically, we have $156.1 million in cash, cash equivalents, and short- and
long-term loan investments. Our capital expenditures in 2002 are expected to be
around $10 million, and we expect operating cash outflow to be minimal relative
to our cash reserves. We continue to seek other alliances or acquisitions and
additional relationships with regard to the strategic development of various
new technologies, especially LCoSmicrodisplays, that may also require us to
make additional capital investments. In such a case, we may need to expand our
loan commitments or pursue alternate methods of financing or raise capital. We
cannot provide assurance that adequate additional loan commitments or
alternative methods of financing will be available or, if available, that they
will be on terms acceptable to us.




ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments

At December 31, 2001, we did not participate in any derivative financial
instruments, or other financial and commodity instruments for which fair value
disclosure would be required under Statement of Financial Accounting Standards
No. 107. We hold no investment securities that would require disclosure of
market risk.

We have certain receivables denominated in Chinese renminbi. To eliminate
our exposure to changes in the U.S. dollar/Chinese renminbi exchange rate, we
have entered into forward contracts to protect future cash flows. We have
designated the forward contracts as cash flow hedges. Accordingly, we account
for changes in the fair value of our forward contracts, based on changes in the
forward exchange rate, with all changes in fair value reported in other
comprehensive income. Amounts in other comprehensive income will be
reclassified into earnings upon settlement of the forward contract. As of
December 31, 2001, we had four forward contracts outstanding with a cumulative
notional value of $4.0 million expiring through April 2002.

Primary Market Risk Exposures

Our primary market risk exposures are in the areas of interest rate risk
and foreign currency exchange rate risk. We have a revolving line of credit
with a variable interest rate of LIBOR (1.86% at December 31, 2001) plus 150
basis points. At December 31, 2001, no borrowings were outstanding under this
line of credit.

We generally sell our products and services and negotiate purchase orders
with our foreign suppliers in U.S. dollars. However, we have certain foreign
currency exchange exposure as a result of our manufacturing operations in the
Philippines and China and our sales and distribution facility in the United
Kingdom. We have not incurred any material exchange gains or losses to date.
Some of the expenses of these foreign operations are denominated in the
Philippine peso, Chinese renminbi, and British pound sterling, respectively.
These expenses include local salaries and wages, utilities, and some operating
supplies. As a result of these sales and expenses, we do have accounts
receivable and cash deposits in local currencies. We believe, however, that
the operating expenses currently incurred in foreign currencies other than the
Chinese renminbi are immaterial, and therefore any associated market risk is
unlikely to have a material adverse effect on our business, results of
operations, or financial condition. Although the Chinese currency currently is
stable, its value in relation to the U.S. dollar is determined by the Chinese
government. There is general speculation that China may devalue its currency.
Devaluation of the Chinese currency could result in translation adjustments to
our balance sheet as well as reportable losses depending on our monetary
balances and outstanding indebtedness at the time of devaluation. The
government of China historically has made it difficult to convert its local
currency into foreign currencies. Although we from time to time may enter

35



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##### Table of Contents



into hedging transactions in order to minimize our exposure to currency
rate fluctuations, the Chinese currency is not freely traded and thus is
difficult to hedge. In addition, the government of China has imposed
restrictions on Chinese currency loans to foreign-operated entities in China.
Based on the foregoing, we cannot provide assurance that fluctuations and
currency exchange rates in the future will not have an adverse effect on our
operations.




ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Reference is made to the financial statements, the report thereon, the
notes thereto, and the supplementary data commencing at page F-1 of this
report, which financial statements, report, notes, and data are incorporated
herein by reference.




ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.




PART III




ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this Item relating to our directors is
incorporated herein by reference to the definitive Proxy Statement to be filed
pursuant to Regulation 14A of the Exchange Act for our 2002 Annual Meeting of
Stockholders. The information required by this Item relating to our executive
officers is included in Item 1, Business  Executive Officers of this report.




ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item is incorporated herein by reference
to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the
Exchange Act for our 2002 Annual Meeting of Stockholders.




ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this Item is incorporated herein by reference
to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the
Exchange Act for our 2002 Annual Meeting of Stockholders.




ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this Item is incorporated herein by reference
to the definitive Proxy Statement to be filed pursuant to Regulation 14A of the
Exchange Act for our 2002 Annual Meeting of Stockholders.




PART IV




ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K



|(a) |  | Financial Statements and Financial Statement Schedule
|--- |  | -----------------------------------------------------



| | (1) |  | Financial Statements are listed in the Index to Financial Statements on page F-1 of this report.
| | --- |  | ------------------------------------------------------------------------------------------------
|
| | (2) |  | Financial Statement Schedule:                                                                   

Schedule II Valuation and Qualifying Accounts and Reserves is set forth on
page S-1 of this report.

Other schedules are omitted because they are not applicable, not required,
or because the required information is included in the consolidated financial
statements or notes thereto.



|(b) |  | Reports on Form 8-K
|--- |  | -------------------

Form 8-K, filed November 5, 2001, Item 9  Regulation FD Disclosure.

36



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##### Table of Contents





|(c) |  | Exhibits
|--- |  | --------

|               |  |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Exhibits                                                                                                                                                                                                                                                                                                                                                                                                                                   
|               |  |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|2              |  | Amended and Restated Agreement and Plan of Reorganization(1)                                                                                                                                                                                                                                                                                                                                                                               
|              
|              
|              
|              
|3(a)           |  | Amended and Restated Certificate of Incorporation of the Company(2)                                                                                                                                                                                                                                                                                                                                                                        
|              
|              
|              
|              
|3(b)           |  | Certificate of Amendment of Restated Certificate of Incorporation(3)                                                                                                                                                                                                                                                                                                                                                                       
|              
|              
|              
|              
|3(c)           |  | Amended and Restated Bylaws of the Company(4)                                                                                                                                                                                                                                                                                                                                                                                              
|              
|              
|              
|              
|4              |  | Form of Certificate of Common Stock(4)                                                                                                                                                                                                                                                                                                                                                                                                     
|              
|              
|              
|              
|4(b)           |  | Rights Agreement, dated as of April 26, 2001, between Three-Five Systems, Inc. and Bank of
New York, as Rights Agent, together with the following exhibits thereof: Exhibit A  Form
of Certificate of Designation of Series A Junior Participating Preferred Stock of
Three-Five Systems, Inc.; Exhibit B  Form of Right Certificate; Exhibit C  Summary of
Rights to Purchase Shares of Preferred Stock of three-Five Systems, Inc. (5)
|              
|              
|              
|              
|10(a)          |  | Amended and Restated 1997 Employee Option Plan (as amended through February 2001)(6)                                                                                                                                                                                                                                                                                                                                                       
|              
|              
|              
|              
|10(c)          |  | Line of Credit Agreement between Three-Five Systems Limited and Barclays Bank, PLC(1)                                                                                                                                                                                                                                                                                                                                                      
|              
|              
|              
|              
|10(g)          |  | Form of Three-Five Systems, Inc. Distributor Franchise Agreement(7)                                                                                                                                                                                                                                                                                                                                                                        
|              
|              
|              
|              
|10(j)          |  | 1993 Stock Option Plan(7)                                                                                                                                                                                                                                                                                                                                                                                                                  
|              
|              
|              
|              
|10(k)          |  | 1994 Automatic Stock Option Plan(8)                                                                                                                                                                                                                                                                                                                                                                                                        
|              
|              
|              
|              
|10(o)          |  | Lease dated April 1, 1994, between Papago Park Center, Inc. and Three-Five Systems, Inc.(9)                                                                                                                                                                                                                                                                                                                                                
|              
|              
|              
|              
|10(v)          |  | 1997 Employee Stock Option Agreement(10)                                                                                                                                                                                                                                                                                                                                                                                                   
|              
|              
|              
|              
|10(w)          |  | Amended and Restated Three-Five Systems, Inc. 1998 Stock Option Plan, amended as of
January 28, 1999, as approved by the Companys stockholders on April 22, 1999(11)                                                                                                                                                                                                                                                                      
|              
|              
|              
|              
|10(x)          |  | Amended and Restated 1994 Stock Option Plan for the Non-Employee Directors(12)                                                                                                                                                                                                                                                                                                                                                             
|              
|              
|              
|              
|10(z)          |  | 401(k) Profit Sharing Plan(13)                                                                                                                                                                                                                                                                                                                                                                                                             
|              
|              
|              
|              
|10(aa)         |  | Credit Agreement dated January 21, 2000, by and among Three-Five Systems, Inc., its
subsidiaries, the Banks named therein, and Imperial Bank Arizona, as Agent and as Issuing
Bank(12)                                                                                                                                                                                                                                                     
|              
|              
|              
|              
|10(cc)         |  | Modification Agreement dated February 1, 2001, by and among Three-Five Systems, Inc., its
subsidiaries, the Banks named in the Credit Agreement, and Imperial Bank as administrative
agent and as Issuing Bank(14)                                                                                                                                                                                                                         
|              
|              
|              
|              
|21             |  | List of Subsidiaries(4)                                                                                                                                                                                                                                                                                                                                                                                                                    
|              
|              
|              
|              
|23             |  | Consent of Arthur Andersen LLP*                                                                                                                                                                                                                                                                                                                                                                                                            



---

|*    |  | Filed herein.                                                                                                                                                                                                                  
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    
|    
|    
|    
|(1)  |  | Incorporated by reference to the Registration Statement on Form S-4 of TF
Consolidation, Inc. (Registration No. 33-33944) as filed March 27, 1990
and declared effective March 27, 1990.                                       
|    
|    
|    
|    
|(2)  |  | Incorporated by reference to the Registrants Form 10-QSB for the quarter
ended March 31, 1994, as filed with the Commission on or about May 12,
1994.                                                                         
|    
|    
|    
|    
|(3)  |  | Incorporated by reference to the Registrants Form S-3/A as filed with
the Commission on May 5, 2000.                                                                                                                          
|    
|    
|    
|    
|(4)  |  | Incorporated by reference to the Registration Statement on Form S-3
(Registration No. 333-84083) as filed on July 30, 1999, as amended by Form
S-3/A filed on August 26, 1999, and declared effective September 27, 1999.      
|    
|    
|    
|    
|(5)  |  | Incorporate by reference to the Registrants Form 8-A as filed with the
Commission on May 10, 2001.                                                                                                                            
|    
|    
|    
|    
|(6)  |  | Incorporated by reference to the Registrants Form S-8 as filed with the
Commission on November 3, 2000.                                                                                                                       
|    
|    
|    
|    
|(7)  |  | Incorporated by reference to the Registration Statement on Form S-1
(Registration No. 33-74788) as filed on February 3, 1994, and declared
effective March 15, 1994.                                                           
|    
|    
|    
|    
|(8)  |  | Incorporated by reference to the Registration Statement on Form S-8
(Registration No. 33-88706) as filed on January 24, 1995.                                                                                                  
|    
|    
|    
|    
|(9)  |  | Incorporated by reference to the Registrants Form 10-K for the fiscal
year ended December 31, 1996, as filed with the Commission on March 14,
1997.                                                                           
|    
|    
|    
|    
|(10) |  | Incorporated by reference to the Registrants Form 10-K for the fiscal
year ended December 31, 1997, as filed with the Commission on March 13,
1998, and as amended by Form 10-K/A filed with the Commission on March 23,
1998.
|    
|    
|    
|    
|(11) |  | Incorporated by reference to the Registration Statement on Form S-8
(Registration No. 333-87875) as filed on September 27, 1999.                                                                                               
|    
|    
|    
|    
|(12) |  | Incorporated by reference to the Registrants Form 10-Q for the quarter
ended June 30, 2001, as filed with the Commission on July 27, 2001.                                                                                    
|    
|    
|    
|    
|(13) |  | Incorporated by reference to the Registration Statement on Form S-8
(Registration No. 333-57933) as filed on June 26, 1998.                                                                                                    
|    
|    
|    
|    
|(14) |  | Incorporated by reference to the Registrants Form 10-K for the fiscal
year ended December 31, 2000, as filed with the Commission on March 13,
2001.                                                                           

37



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.

|                     |  |                          |  |                                                                          
|-------------------- |  | ------------------------ |  | -------------------------------------------------------------------------
|                     |  | THREE-FIVE SYSTEMS, INC.
|                    
|                    
|                    
|                    
|                     |  |                          |  |                                                                          
|                    
|                    
|                    
|                    
|Date: March 19, 2002 |  | By:                      |  | /s/ Jack L. Saltich
Jack L. Saltich
President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

|                                             |  |                                                                                                                     |  |               
|-------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------- |  | --------------
|Name                                         |  | Title                                                                                                               |  | Date          
|                                             |  |                                                                                                                     |  |               
|                                             |  |                                                                                                                     |  |               
|                                            
|                                            
|                                            
|                                            
|/s/ Jack L. Saltich

Jack L. Saltich         |  | President, Chief Executive Officer
(Principal Executive Officer), and Director                                      |  | March 19, 2002
|                                            
|                                            
|                                            
|                                            
|                                             |  |                                                                                                                     |  |               
|                                            
|                                            
|                                            
|                                            
|/s/ Jeffrey D. Buchanan

Jeffrey D. Buchanan |  | Executive Vice President, Chief Financial
Officer, Secretary, Treasurer (Principal
Financial Officer), and Director |  | March 19, 2002
|                                            
|                                            
|                                            
|                                            
|                                             |  |                                                                                                                     |  |               
|                                            
|                                            
|                                            
|                                            
|/s/ Robert T. Berube

Robert T. Berube       |  | Corporate Controller (Principal Accounting
Officer)                                                                 |  | March 19, 2002
|                                            
|                                            
|                                            
|                                            
|                                             |  |                                                                                                                     |  |               
|                                            
|                                            
|                                            
|                                            
|/s/ David C. Malmberg
David C. Malmberg      |  | Director                                                                                                            |  | March 19, 2002
|                                            
|                                            
|                                            
|                                            
|                                             |  |                                                                                                                     |  |               
|                                            
|                                            
|                                            
|                                            
|/s/ Kenneth M. Julien
Kenneth M. Julien      |  | Director                                                                                                            |  | March 19, 2002
|                                            
|                                            
|                                            
|                                            
|                                             |  |                                                                                                                     |  |               
|                                            
|                                            
|                                            
|                                            
|/s/ Thomas A. Werner
Thomas A. Werner        |  | Director                                                                                                            |  | March 19, 2002
|                                            
|                                            
|                                            
|                                            
|                                             |  |                                                                                                                     |  |               
|                                            
|                                            
|                                            
|                                            
|/s/ David P. Chavoustie
David P. Chavoustie  |  | Director                                                                                                            |  | March 19, 2002
|                                            
|                                            
|                                            
|                                            
|                                             |  |                                                                                                                     |  |               
|                                            
|                                            
|                                            
|                                            
|/s/ Murray Goldman
Murray Goldman            |  | Director                                                                                                            |  | March 19, 2002

38



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##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

|                                                                                                                  |  |      |     | 
|----------------------------------------------------------------------------------------------------------------- |  | ---- | --- | 
|                                                                                                                  |  | Page
|                                                                                                                  |  |     
|Report of Independent Public Accountants                                                                          |  |      | F-2 | 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|Consolidated Balance Sheets as of December 31, 2000 and 2001                                                      |  |      | F-3 | 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|Consolidated Statements of Operations for the years ended
December 31, 1999, 2000 and 2001                        |  |      | F-4 | 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|Consolidated Statements of Stockholders Equity for the years
ended December 31, 1999, 2000 and 2001              |  |      | F-5 | 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|Consolidated Statements of Comprehensive Income (Loss) for the years
ended December 31, 1999, 2000 and 2001       |  |      | F-6 | 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|Consolidated Statements of Cash Flows for the years ended
December 31, 1999, 2000 and 2001                        |  |      | F-7 | 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|Notes to Consolidated Financial Statements                                                                        |  |      | F-8 | 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|                                                                                                                 
|Schedule II  Valuation and Qualifying Accounts and Reserves
for the years ended December 31, 1999, 2000 and 2001 |  |      | S-1 | 

F-1



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##### Table of Contents



REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Three-Five Systems, Inc.:

We have audited the accompanying consolidated balance sheets of THREE-FIVE
SYSTEMS, INC. (the Company) (a Delaware corporation) and subsidiaries as of
December 31, 2000 and 2001, and the related consolidated statements of
operations, stockholders equity, comprehensive income (loss) and cash flows
for each of the three years in the period ended December 31, 2001. These
financial statements and the schedule referred to below are the responsibility
of the Companys management. Our responsibility is to express an opinion on
these financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of the Company and
subsidiaries as of December 31, 2000 and 2001, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2001, in conformity with accounting principles generally accepted
in the United States.

Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed on the Index to
Consolidated Financial Statements is presented for purposes of complying with
the Securities and Exchange Commissions rules and is not part of the basic
financial statements. This schedule has been subjected to the auditing
procedures applied in the audits of the basic financial statements and, in our
opinion, fairly states in all material respects the financial data required to
be set forth therein in relation to the basic financial statements taken as a
whole.

|                                  |  |                        
|--------------------------------- |  | -----------------------
|                                  |  | /s/ ARTHUR ANDERSEN LLP
|                                 
|                                 
|                                 
|                                 
|Phoenix, Arizona
January 21, 2002 |  |                        

F-2



---



##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)

|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |         |         |         | 
|-------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------- | -------------------------- | ------- | ------------ | ------- | ------- | ------- | ------- | ------- | 
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         | December 31,
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |             
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         | 2000         |         | 2001   
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |        
|ASSETS                                                                     |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|Current Assets:                                                            |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Cash and cash equivalents                                                                                                                                                                                                                            |                           | $                          | 45,645  |              |         | $       | 37,003  |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Short-term investments                                                                                                                                                                                                                               |                           |                            | 119,926 |              |         |         | 110,016 |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Accounts receivable, net                                                                                                                                                                                                                             |                           |                            | 23,635  |              |         |         | 18,102  |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Inventories                                                                                                                                                                                                                                          |                           |                            | 20,516  |              |         |         | 15,629  |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Taxes receivable                                                                                                                                                                                                                                     |                           |                            |        |              |         |         | 3,960   |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Deferred tax asset                                                                                                                                                                                                                                   |                           |                            | 4,346   |              |         |         | 3,930   |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Other current assets                                                                                                                                                                                                                                 |                           |                            | 1,778   |              |         |         | 2,104   |        
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                           |                                                                                                                                                                                                                                                      | Total current assets      |                            |         | 215,846      |         |         |         | 190,744 |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|Long-term Investments                                                      |                                                                                                                                                                                                                                                      |                           | 4,534                      |         |              |         | 9,034   |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|Property, Plant and Equipment, net                                         |                                                                                                                                                                                                                                                      |                           | 38,093                     |         |              |         | 38,353  |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|Intangibles, net                                                           |                                                                                                                                                                                                                                                      |                           | 5,161                      |         |              |         | 5,886   |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|Long-term Deferred Tax Asset, net                                          |                                                                                                                                                                                                                                                      |                           |                           |         |              |         | 219     |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|Other Assets, net                                                          |                                                                                                                                                                                                                                                      |                           | 4,209                      |         |              |         | 1,652   |        
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                           |                                                                                                                                                                                                                                                      | $                         | 267,843                    |         |              | $       | 245,888 |        
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|LIABILITIES AND STOCKHOLDERS EQUITY                                       |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|Current Liabilities:                                                       |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Accounts payable                                                                                                                                                                                                                                     |                           | $                          | 11,404  |              |         | $       | 14,785  |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Accrued liabilities                                                                                                                                                                                                                                  |                           |                            | 7,005   |              |         |         | 4,130   |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Current taxes payable                                                                                                                                                                                                                                |                           |                            | 239     |              |         |         |        |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Term loan                                                                                                                                                                                                                                            |                           |                            | 2,706   |              |         |         | 2,706   |        
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                           |                                                                                                                                                                                                                                                      | Total current liabilities |                            |         | 21,354       |         |         |         | 21,621  |        
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|Deferred Tax Liability                                                     |                                                                                                                                                                                                                                                      |                           | 4,487                      |         |              |         |        |        
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|Commitments and Contingencies
Minority Interest in Consolidated Subsidiary |                                                                                                                                                                                                                                                      |                           |                           |         |              |         | 323     |        
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |         |        
|Stockholders Equity:                                                      |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Preferred stock, $.01 par value; 1,000,000 shares
authorized, no shares issued or outstanding                                                                                                                                                        |                           |                            |        |              |         |         |        |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Common stock, $.01 par value; 60,000,000 shares
authorized, 21,655,778 shares issued, 21,414,258
shares outstanding at December 31, 2000; 60,000,000
shares authorized, 21,894,628 shares issued,
21,503,911 shares outstanding at December 31, 2001 |                           |                            | 217     |              |         |         | 219     |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Additional paid-in capital                                                                                                                                                                                                                           |                           |                            | 198,215 |              |         |         | 200,395 |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Retained earnings                                                                                                                                                                                                                                    |                           |                            | 48,430  |              |         |         | 30,666  |        
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Stock subscription note receivable                                                                                                                                                                                                                   |                           |                            |        |              |         |         | (163    | )      
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Accumulated other comprehensive loss                                                                                                                                                                                                                 |                           |                            | (234    | )            |         |         | (21     | )      
|                                                                          
|                                                                          
|                                                                          
|                                                                          
|                                                                           | Less  Treasury stock, at cost, 241,520 shares
at December 31, 2000 and 390,717 shares at December
31, 2001                                                                                                                                          |                           |                            | (4,626  | )            |         |         | (7,152  | )      
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                           |                                                                                                                                                                                                                                                      |                           | Total stockholders equity |         |              | 242,002 |         |         |         | 223,944 | 
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        
|                                                                           |                                                                                                                                                                                                                                                      | $                         | 267,843                    |         |              | $       | 245,888 |        
|                                                                           |                                                                                                                                                                                                                                                      |                           |                            |         |              |         |         |        

The accompanying notes are an integral part of these consolidated balance sheets.

F-3



---



##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)

|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |            |         |  
|---------------------------------------------------- | ----------------------------------------- | ----------------------- | ------- | ------------ | ----- | ---- | ------- | ---------- | ------ | - | ------- | ---------- | ------- | -
|                                                     |                                           |                         |         | Years Ended 
|                                                     |                                           |                         |         | December 31,
|                                                     |                                           |                         |         |             
|                                                     |                                           |                         |         | 1999         |       | 2000 |         | 2001      
|                                                     |                                           |                         |         |              |       |      |         |           
|Net Sales                                            |                                           | $                       | 147,408 |              |       | $    | 160,684 |            |        | $ | 119,136 |           
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|Costs and Expenses:                                  |                                           |                         |         |              |       |      |         |            |        |   |         |           
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Cost of sales                             |                         |         | 117,583      |       |      |         | 124,724    |        |   |         | 121,514    |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Selling, general and administrative       |                         |         | 11,170       |       |      |         | 9,501      |        |   |         | 10,130     |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Research, development and engineering     |                         |         | 8,745        |       |      |         | 13,295     |        |   |         | 17,618     |        
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|                                                     |                                           |                         | 137,498 |              |       |      | 147,520 |            |        |   | 149,262 |           
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|                                                     |                                           | Operating income (loss) |         |              | 9,910 |      |         |            | 13,164 |   |         |            | (30,126 | )
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|Other Income (Expense):                              |                                           |                         |         |              |       |      |         |            |        |   |         |           
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Interest, net                             |                         |         | 51           |       |      |         | 7,374      |        |   |         | 7,266      |        
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Loss on investment in start-up company    |                         |         |             |       |      |         |           |        |   |         | (3,820     | )      
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Other, net                                |                         |         | (69          | )     |      |         | (190       | )      |   |         | 4          |        
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|                                                     |                                           |                         | (18     | )            |       |      | 7,184   |            |        |   | 3,450   |           
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|Minority Interest in Loss of Consolidated Subsidiary |                                           |                         |        |              |       |      |        |            |        |   | 167     |           
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|Income (Loss) before Income Taxes                    |                                           |                         | 9,892   |              |       |      | 20,348  |            |        |   | (26,509 | )         
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Provision for (benefit from) income taxes |                         |         | 2,968        |       |      |         | 5,514      |        |   |         | (8,745     | )      
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|Net Income (Loss)                                    |                                           | $                       | 6,924   |              |       | $    | 14,834  |            |        | $ | (17,764 | )         
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|Earnings (Loss) Per Common Share:                    |                                           |                         |         |              |       |      |         |            |        |   |         |           
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Basic                                     |                         | $       | 0.44         |       |      | $       | 0.73       |        |   | $       | (0.83      | )      
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|                                                     | Diluted                                   |                         | $       | 0.43         |       |      | $       | 0.69       |        |   | $       | (0.83      | )      
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|Weighted Average Number of Common Shares:            |                                           |                         |         |              |       |      |         |            |        |   |         |           
|                                                    
|                                                    
|                                                    
|                                                    
|                                                     | Basic                                     |                         |         | 15,563,121   |       |      |         | 20,457,226 |        |   |         | 21,401,159 |        
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           
|                                                     | Diluted                                   |                         |         | 16,005,050   |       |      |         | 21,635,524 |        |   |         | 21,401,159 |        
|                                                     |                                           |                         |         |              |       |      |         |            |        |   |         |           

The accompanying notes are an integral part of these consolidated financial statements.

F-4



---



##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
For the Years Ended December 31, 1999, 2000 and 2001
(in thousands, except share data)

|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  |               |      |       |  |             |      |       |  |   |        |   |  |   |         |   |  |  |  | 
|---------------------------------------------- |  | ------------- | ---------- | ------- |  | -------- | --- | -------- |  | ---------- | ------- | -------- |  | ------------- | ------- | ------------ |  | ------------- | ---- | ----- |  | ----------- | ---- | ----- |  | - | ------ | - |  | - | ------- | - |  |  |  | 
|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  |               |      |       |  | Accumulated
|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  | Stock         |      | Other |  |             |      |       |  |   |        |   |  |   |         |  
|                                               |  |               |            |         |  |          |     |          |  | Additional |         |          |  |               |         | Subscription |  | Comprehensive |      |       |  |             |      | Total |  |   |        |  
|                                               |  | Common Stock  |            | Paid-in |  | Retained |     | Note     |  | Income     |         | Treasury |  | Stockholders' |         |              |  |              
|                                               |  | Shares Issued |            | Amount  |  | Capital  |     | Earnings |  | Receivable |         | (Loss)   |  | Stock         |         | Equity       |  |               |      |      
|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  |               |      |      
|Balance, December 31, 1998                     |  |               | 15,949,802 |         |  | $        | 159 |          |  | $          | 32,484  |          |  | $             | 26,770  |              |  | $             |     |       |  | $           | 8    |       |  | $ | (8,325 | ) |  | $ | 51,096  |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Net income                                     |  |               |           |         |  |          |    |          |  |            |        |          |  |               | 6,924   |              |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 6,924   |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Foreign currency translation
adjustments       |  |               |           |         |  |          |    |          |  |            |        |          |  |               |        |              |  |               |     |       |  |             | (1   | )     |  |   |       |   |  |   | (1      | ) |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Stock options exercised                        |  |               | 150,650    |         |  |          | 2   |          |  |            | 184     |          |  |               | (1      | )            |  |               |     |       |  |             |     |       |  |   | 41     |   |  |   | 226     |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Warrants issued                                |  |               |           |         |  |          |    |          |  |            | 555     |          |  |               |        |              |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 555     |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Tax benefit on stock option
exercises          |  |               |           |         |  |          |    |          |  |            | 30      |          |  |               |        |              |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 30      |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Sale of common stock, net of
offering expenses |  |               | 2,758,686  |         |  |          | 28  |          |  |            | 34,135  |          |  |               | (54     | )            |  |               |     |       |  |             |     |       |  |   | 8,281  |   |  |   | 42,390  |   |  |  |  | 
|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  |               |      |       |  |             |      |       |  |   |        |   |  |   |         |   |  |  |  | 
|Balance, December 31, 1999                     |  |               | 18,859,138 |         |  |          | 189 |          |  |            | 67,388  |          |  |               | 33,639  |              |  |               |     |       |  |             | 7    |       |  |   | (3     | ) |  |   | 101,220 |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  |               |      |       |  |             |      |       |  |   |        |   |  |   |         |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Net income                                     |  |               |           |         |  |          |    |          |  |            |        |          |  |               | 14,834  |              |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 14,834  |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Foreign currency translation
adjustments       |  |               |           |         |  |          |    |          |  |            |        |          |  |               |        |              |  |               |     |       |  |             | (241 | )     |  |   |       |   |  |   | (241    | ) |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Stock options exercised                        |  |               | 222,126    |         |  |          | 2   |          |  |            | 1,477   |          |  |               |        |              |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 1,479   |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Warrants exercised, net                        |  |               | 102,014    |         |  |          | 1   |          |  |            |        |          |  |               |        |              |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 1       |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Tax benefit on stock option
exercises          |  |               |           |         |  |          |    |          |  |            | 674     |          |  |               |        |              |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 674     |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Purchase of treasury stock                     |  |               |           |         |  |          |    |          |  |            |        |          |  |               |        |              |  |               |     |       |  |             |     |       |  |   | (4,623 | ) |  |   | (4,623  | ) |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Sale of common stock, net of
offering expenses |  |               | 2,472,500  |         |  |          | 25  |          |  |            | 128,676 |          |  |               | (43     | )            |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 128,658 |   |  |  |  | 
|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  |               |      |       |  |             |      |       |  |   |        |   |  |   |         |   |  |  |  | 
|Balance, December 31, 2000                     |  |               | 21,655,778 |         |  |          | 217 |          |  |            | 198,215 |          |  |               | 48,430  |              |  |               |     |       |  |             | (234 | )     |  |   | (4,626 | ) |  |   | 242,002 |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  |               |      |       |  |             |      |       |  |   |        |   |  |   |         |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Net loss                                       |  |               |           |         |  |          |    |          |  |            |        |          |  |               | (17,764 | )            |  |               |     |       |  |             |     |       |  |   |       |   |  |   | (17,764 | ) |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Unrealized gains on investments                |  |               |           |         |  |          |    |          |  |            |        |          |  |               |        |              |  |               |     |       |  |             | 260  |       |  |   |       |   |  |   | 260     |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Foreign currency translation
adjustments       |  |               |           |         |  |          |    |          |  |            |        |          |  |               |        |              |  |               |     |       |  |             | (47  | )     |  |   |       |   |  |   | (47     | ) |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Stock subscription note receivable             |  |               |           |         |  |          |    |          |  |            | 410     |          |  |               |        |              |  |               | (163 | )     |  |             |     |       |  |   |       |   |  |   | 247     |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Stock options exercised and other              |  |               | 238,850    |         |  |          | 2   |          |  |            | 1,182   |          |  |               |        |              |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 1,184   |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Tax benefit on stock option
exercises          |  |               |           |         |  |          |    |          |  |            | 588     |          |  |               |        |              |  |               |     |       |  |             |     |       |  |   |       |   |  |   | 588     |   |  |  |  | 
|                                              
|                                              
|                                              
|                                              
|Purchase of treasury stock                     |  |               |           |         |  |          |    |          |  |            |        |          |  |               |        |              |  |               |     |       |  |             |     |       |  |   | (2,526 | ) |  |   | (2,526  | ) |  |  |  | 
|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  |               |      |       |  |             |      |       |  |   |        |   |  |   |         |   |  |  |  | 
|Balance, December 31, 2001                     |  |               | 21,894,628 |         |  | $        | 219 |          |  | $          | 200,395 |          |  | $             | 30,666  |              |  | $             | (163 | )     |  | $           | (21  | )     |  | $ | (7,152 | ) |  | $ | 223,944
|                                               |  |               |            |         |  |          |     |          |  |            |         |          |  |               |         |              |  |               |      |       |  |             |      |       |  |   |        |   |  |   |         |   |  | 

The accompanying notes are an integral part of these consolidated financial statements.

F-5



---



##### Table of Contents



CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
For the Years Ended December 31, 1999, 2000 and 2001
(in thousands)

|                                                 |                                         |                             |       |              |       |      |        |      |        |   |         |     |         |  
|------------------------------------------------ | --------------------------------------- | --------------------------- | ----- | ------------ | ----- | ---- | ------ | ---- | ------ | - | ------- | --- | ------- | -
|                                                 |                                         |                             |       | Years Ended 
|                                                 |                                         |                             |       | December 31,
|                                                 |                                         |                             |       |             
|                                                 |                                         |                             |       | 1999         |       | 2000 |        | 2001
|                                                 |                                         |                             |       |              |       |      |        |     
|Net Income (Loss)                                |                                         | $                           | 6,924 |              |       | $    | 14,834 |      |        | $ | (17,764 | )  
|                                                
|                                                
|                                                
|                                                
|Other Comprehensive Income (Loss), net of taxes: |                                         |                             |       |              |       |      |        |      |        |   |         |    
|                                                
|                                                
|                                                
|                                                
|                                                 | Unrealized gains                        |                             |       |             |       |      |        |     |        |   |         | 260 |        
|                                                
|                                                
|                                                
|                                                
|                                                 | Foreign currency translation adjustment |                             |       | (1           | )     |      |        | (241 | )      |   |         | (47 | )      
|                                                 |                                         |                             |       |              |       |      |        |      |        |   |         |    
|                                                 |                                         | Comprehensive income (loss) |       | $            | 6,923 |      |        | $    | 14,593 |   |         | $   | (17,551 | )
|                                                 |                                         |                             |       |              |       |      |        |      |        |   |         |    

The accompanying notes are an integral part of these consolidated financial statements.

F-6



---



##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |        |        |        |  
|-------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------- | --------------------------------------------------------------- | --------------------------------------------------- | ----- | ------------ | ------- | -------- | ----- | ------ | -------- | -------- | ------ | ------ | ------ | -
|                                                                                                   |                                                                     |                                                                 |                                                     |       | Years Ended 
|                                                                                                   |                                                                     |                                                                 |                                                     |       | December 31,
|                                                                                                   |                                                                     |                                                                 |                                                     |       |             
|                                                                                                   |                                                                     |                                                                 |                                                     |       | 1999         |         | 2000     |       | 2001  
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |       
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                              |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Net income (loss)                                                                                  |                                                                     | $                                                               | 6,924                                               |       |              | $       | 14,834   |       |        | $        | (17,764  | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities: |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   | Depreciation and amortization                                       |                                                                 |                                                     | 5,898 |              |         |          | 6,039 |        |          |          | 5,961  |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   | Minority interest in consolidated subsidiary                        |                                                                 |                                                     |      |              |         |          |      |        |          |          | (167   | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   | Provision for (reduction of) accounts receivable valuation reserves |                                                                 |                                                     | 234   |              |         |          | (311  | )      |          |          | (180   | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   | Loss on disposal of assets                                          |                                                                 |                                                     |      |              |         |          | 74    |        |          |          | 1,371  |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   | Tax benefit on stock option exercises                               |                                                                 |                                                     | 30    |              |         |          | 674   |        |          |          | 588    |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   | Benefit from deferred taxes, net                                    |                                                                 |                                                     | (723  | )            |         |          | (626  | )      |          |          | (4,575 | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   | Loss on investment in start-up company                              |                                                                 |                                                     |      |              |         |          |      |        |          |          | 3,820  |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   | Changes in assets and liabilities:                                  |                                                                 |                                                     |       |              |         |          |       |        |          |          |        |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   |                                                                     | (Increase) decrease in accounts receivable                      |                                                     |       | (2,519       | )       |          |       | (2,438 | )        |          |        | 5,713  |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   |                                                                     | (Increase) decrease in inventories                              |                                                     |       | 149          |         |          |       | (8,172 | )        |          |        | 4,887  |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   |                                                                     | (Increase) decrease in other assets                             |                                                     |       | 1,272        |         |          |       | (941   | )        |          |        | (339   | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   |                                                                     | Increase (decrease) in accounts payable and accrued liabilities |                                                     |       | 5,654        |         |          |       | (2,567 | )        |          |        | 506    |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                   |                                                                     | Increase (decrease) in taxes payable/receivable                 |                                                     |       | 1,515        |         |          |       | (497   | )        |          |        | (3,914 | )     
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                   |                                                                     |                                                                 | Net cash provided by (used in) operating activities |       |              | 18,434  |          |       |        | 6,069    |          |        |        | (4,093 | )
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                              |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Purchase of property, plant and equipment                                                          |                                                                     |                                                                 | (7,904                                              | )     |              |         | (8,279   | )     |        |          | (6,843   | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Purchase of intangibles                                                                            |                                                                     |                                                                 | (4,633                                              | )     |              |         | (528     | )     |        |          | (1,474   | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Purchase of investments                                                                            |                                                                     |                                                                 |                                                    |       |              |         | (738,888 | )     |        |          | (222,619 | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Proceeds from maturities/sales of investments                                                      |                                                                     |                                                                 |                                                    |       |              |         | 614,428  |       |        |          | 228,289  |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Payments on stock subscription note receivable                                                     |                                                                     |                                                                 |                                                    |       |              |         |         |       |        |          | 247      |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Other investments                                                                                  |                                                                     |                                                                 |                                                    |       |              |         | (500     | )     |        |          | (1,250   | )     
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                   |                                                                     |                                                                 | Net cash used in investing activities               |       |              | (12,537 | )        |       |        | (133,767 | )        |        |        | (3,650 | )
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                              |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Net proceeds from (payments on) notes payable to banks                                             |                                                                     |                                                                 | (8,095                                              | )     |              |         | 2,706    |       |        |          |         |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Stock options and warrants exercised                                                               |                                                                     |                                                                 | 226                                                 |       |              |         | 1,480    |       |        |          | 1,184    |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Minority Interest                                                                                  |                                                                     |                                                                 |                                                    |       |              |         |         |       |        |          | 490      |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Purchase of treasury stock                                                                         |                                                                     |                                                                 |                                                    |       |              |         | (4,623   | )     |        |          | (2,526   | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Net proceeds from equity offering                                                                  |                                                                     |                                                                 | 42,390                                              |       |              |         | 128,658  |       |        |          |         |       
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                   |                                                                     |                                                                 | Net cash provided by (used in) financing activities |       |              | 34,521  |          |       |        | 128,221  |          |        |        | (852   | )
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|Effect of exchange rate changes on cash and cash equivalents                                       |                                                                     |                                                                 | (1                                                  | )     |              |         | (241     | )     |        |          | (47      | )     
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                               |                                                                     |                                                                 | 40,417                                              |       |              |         | 282      |       |        |          | (8,642   | )     
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|CASH AND CASH EQUIVALENTS, beginning of year                                                       |                                                                     |                                                                 | 4,946                                               |       |              |         | 45,363   |       |        |          | 45,645   |       
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|CASH AND CASH EQUIVALENTS, end of year                                                             |                                                                     | $                                                               | 45,363                                              |       |              | $       | 45,645   |       |        | $        | 37,003   |       
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|SUPPLEMENTAL CASH FLOW INFORMATION:                                                                |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Interest paid                                                                                      |                                                                     | $                                                               | 914                                                 |       |              | $       | 751      |       |        | $        | 201      |       
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|Income taxes paid (refunded)                                                                       |                                                                     | $                                                               | 2,209                                               |       |              | $       | 6,197    |       |        | $        | (808     | )     
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING
ACTIVITIES:                            |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       
|                                                                                                  
|                                                                                                  
|                                                                                                  
|                                                                                                  
|Value of warrants granted                                                                          |                                                                     | $                                                               | 555                                                 |       |              | $       |         |       |        | $        |         |       
|                                                                                                   |                                                                     |                                                                 |                                                     |       |              |         |          |       |        |          |          |       

The accompanying notes are an integral part of these consolidated financial statements.

F-7



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##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES




NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1999, 2000 and 2001



|(1) |  | Organization and Operations:
|--- |  | ----------------------------

We design and manufacture display modules for use in the end products of
original equipment manufacturers, or OEMs. We currently specialize in custom
liquid crystal display, or LCD, components and technology. We collaborate
closely with our customers in providing our design and manufacturing services.
Our LCD modules are used in mobile handsets and other wireless communication
devices as well as in the data collection, medical electronics, and other
commercial and consumer marketplaces. We refer to this business as our direct
view display business. In 2001, Motorola was our largest customer. In addition
to our direct view display business, we are pursuing the commercialization of
our liquid crystal-on-silicon, or LCoS, microdisplays following substantial
research and development over the past several years. We market our services
in North America, Europe, and Asia, primarily through a direct technical sales
force.

Three-Five Systems Limited (Limited), a wholly owned subsidiary, is
incorporated in the United Kingdom. Limited sells and distributes our products
to customers on the European continent.

Three-Five Systems Pacific, Inc. (Pacific), a wholly owned Philippines
corporation, manufactures our products. Pacific also manages and assists
production personnel of a third-party subcontractor that will be engaged until
April 2002 when we will completely move into our newly built, leased facility
in the Philippines.

Three-Five Systems (Beijing) Co., Ltd. (Beijing), a wholly owned
subsidiary, manufactures and sells our products to customers primarily located
in Asia.

During the second quarter of 2001, we formed a new subsidiary, Three-D
OLED L.L.C. We own 51% of this new subsidiary, and DuPont Displays, a business
unit of DuPont Corporation owns, 49%. The companies have pledged $3.0 million
to the venture. Our share of that obligation is slightly over $1.5 million.
This new venture will design, assemble, and market OLED (Organic Light Emitting
Diode) display modules to OEMs worldwide. The venture will focus on glass
substrate, passive matrix OLED displays. OLED technology utilizes advanced
materials to produce bright, high-contrast, emissive displays. The venture will
be headquartered in Tempe, Arizona, within our existing corporate headquarters,
and controlled by us. The venture will utilize the glass panel output of a new
high-volume manufacturing plant located in Taiwan, announced by DuPont and
RiTdisplay Technology Corporation. The venture may also use other OLED glass
panel sources. OLED display modules will be assembled at our display module
assembly facilities in Beijing and Manila. As we control this new subsidiary,
it has been consolidated in the accompanying financial statements with DuPont
Displays 49% ownership interest accounted for as a minority interest.



|(2) |  | Summary of Significant Accounting Policies:
|--- |  | -------------------------------------------

Principles of Consolidation and Preparation of Financial Statements

The consolidated financial statements include our accounts and those of
our subsidiaries. All material intercompany transactions and balances have been
eliminated.

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires us to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

F-8



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##### Table of Contents



Concentration of Credit Risk

Our strategy involves concentrating our efforts on providing design and
production services to leading companies in a limited number of fast-growing
industries. We have been undertaking substantial efforts to diversify our
business, broaden our customer base, and expand our markets. Product sales for
our historical major customer accounted for approximately 86%, 87% and 85% of
our net sales in 1999, 2000 and 2001, respectively. Sales to this customer
related to our direct view display operating segment. Since 1998, no other
customer has accounted for more than 10% of our net sales. A significant
decrease in orders for our products from our historical major customer or a
decline in the cellular telephone industry would result in a material adverse
impact on our results of operations and financial position.

The significant amount of sales to a few customers results in certain
concentrations of credit risk for us. Our accounts receivable balance at
December 31, 2000 and 2001 included 76% and 77%, respectively, from our
historical largest customer. The remaining accounts receivable balances are
mainly related to customers from our direct view display operating segment.
These customers are located primarily in the United States, Asia, and Europe.

Fair Value of Financial Instruments

We have determined the estimated fair value of financial instruments using
available market information and valuation methodologies. Estimating fair
values requires considerable judgment. Accordingly, the estimates may not be
indicative of amounts that would be realized in a current market exchange. The
carrying values of cash, accounts receivable, and accounts payable approximate
fair value due to the short maturities of these instruments. In addition, at
December 31, 2001, the carrying amount on the term loan is estimated to
approximate fair value as the actual interest rate is consistent with rates
estimated to be currently available for debt with similar terms and remaining
maturities.

Cash and Cash Equivalents

For purposes of the statements of cash flows, all highly liquid
investments with an original maturity of three months or less are considered to
be cash equivalents. Cash equivalents consist of investments in commercial
paper, marketable debt securities, money market mutual funds, and U.S.
government agencies obligations. A portion of our funds held in money market
mutual funds are invested in repurchase agreements. These repurchase
agreements are collateralized by U.S. Treasury and Government obligations.
Cash and cash equivalents at December 31 consists of the following (in
thousands):

|                           |                                   |   |              |        |      |   |        |        | 
|-------------------------- | --------------------------------- | - | ------------ | ------ | ---- | - | ------ | ------ | 
|                           |                                   |   | December 31,
|                           |                                   |   |             
|                           |                                   |   | 2000         |        | 2001
|                           |                                   |   |              |        |     
|Cash and cash equivalents: |                                   |   |              |        |      |   |        |       
|                          
|                          
|                          
|                          
|                           | Cash                              |   | $            | 3,686  |      |   | $      | 6,992  | 
|                          
|                          
|                          
|                          
|                           | Commercial paper                  |   |              | 9,106  |      |   |        |       | 
|                          
|                          
|                          
|                          
|                           | Certificates of deposit           |   |              |       |      |   |        | 5,014  | 
|                          
|                          
|                          
|                          
|                           | Money market                      |   |              | 30,553 |      |   |        | 10,044 | 
|                          
|                          
|                          
|                          
|                           | U.S. government agency securities |   |              |       |      |   |        | 7,445  | 
|                          
|                          
|                          
|                          
|                           | Corporate notes and bonds         |   |              | 2,300  |      |   |        | 7,508  | 
|                           |                                   |   |              |        |      |   |        |        | 
|                           |                                   | $ | 45,645       |        |      | $ | 37,003 |       
|                           |                                   |   |              |        |      |   |        |        | 

Investments

Short-term investments have original maturities greater than three months
and remaining maturities of less than one year. Debt securities with remaining
maturities greater than one year are classified as long-term investments. All
short-term and long-term investments are classified as available for sale and
are presented at market value using the specific identification method.
Unrealized gains and losses are reflected in other comprehensive income.
Realized gains and losses are included in results of operations. Short-term
and long-term investments consist of the following at (in thousands):

F-9



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##### Table of Contents



|                        |                                   |   |              |        |      |   |         |        | 
|----------------------- | --------------------------------- | - | ------------ | ------ | ---- | - | ------- | ------ | 
|                        |                                   |   | December 31,
|                        |                                   |   |             
|                        |                                   |   | 2000         |        | 2001
|                        |                                   |   |              |        |     
|Short-term investments: |                                   |   |              |        |      |   |         |       
|                       
|                       
|                       
|                       
|                        | Certificates of deposit           |   | $            | 11,303 |      |   | $       | 14,970 | 
|                       
|                       
|                       
|                       
|                        | Corporate notes and bonds         |   |              | 55,024 |      |   |         | 63,883 | 
|                       
|                       
|                       
|                       
|                        | U.S. government agency securities |   |              | 16,685 |      |   |         | 28,967 | 
|                       
|                       
|                       
|                       
|                        | Commercial paper                  |   |              | 36,914 |      |   |         | 2,196  | 
|                        |                                   |   |              |        |      |   |         |       
|                        |                                   | $ | 119,926      |        |      | $ | 110,016 |       
|                        |                                   |   |              |        |      |   |         |        | 

|                       |                           |  |              |       |      |  |   |       | 
|---------------------- | ------------------------- |  | ------------ | ----- | ---- |  | - | ----- | 
|                       |                           |  | December 31,
|                       |                           |  |             
|                       |                           |  | 2000         |       | 2001
|                       |                           |  |              |       |     
|Long-term investments: |                           |  |              |       |      |  |   |      
|                      
|                      
|                      
|                      
|                       | Corporate notes and bonds |  | $            | 4,534 |      |  | $ | 9,034 | 
|                       |                           |  |              |       |      |  |   |       | 

Inventories

Inventories are stated at the lower of cost (first-in, first-out) or net
realizable value and consist of the following at (in thousands):

|                |  |              |        |      |  |   |        | 
|--------------- |  | ------------ | ------ | ---- |  | - | ------ | 
|                |  | December 31,
|                |  |             
|                |  | 2000         |        | 2001
|                |  |              |        |     
|Raw materials   |  | $            | 15,898 |      |  | $ | 11,535 | 
|               
|               
|               
|               
|Work-in-process |  |              | 1,904  |      |  |   | 964    | 
|               
|               
|               
|               
|Finished goods  |  |              | 2,714  |      |  |   | 3,130  | 
|                |  |              |        |      |  |   |        | 
|                |  | $            | 20,516 |      |  | $ | 15,629 | 
|                |  |              |        |      |  |   |        | 

Property, Plant, and Equipment

Property, plant, and equipment is recorded at cost and generally is
depreciated using the straight-line method over the estimated useful lives of
the respective assets, which range from three to 39 years. Major additions and
betterments are capitalized, while replacements, maintenance, and repairs that
do not extend the useful lives of the assets are charged to operations as
incurred. Depreciation expense totaled $5,860,000, $6,024,000, and $5,212,000
for the years ended December 31, 1999, 2000, and 2001, respectively. Property,
plant, and equipment consist of the following at (in thousands):

|                              |  |              |         |      |  |   |         |  
|----------------------------- |  | ------------ | ------- | ---- |  | - | ------- | -
|                              |  | December 31,
|                              |  |             
|                              |  | 2000         |         | 2001
|                              |  |              |         |     
|Building and improvements     |  | $            | 16,426  |      |  | $ | 16,476  |  
|                             
|                             
|                             
|                             
|Furniture and equipment       |  |              | 48,601  |      |  |   | 53,728  |  
|                              |  |              |         |      |  |   |         |  
|                              |  |              | 65,027  |      |  |   | 70,204  |  
|                             
|                             
|                             
|                             
|Less accumulated depreciation |  |              | (26,934 | )    |  |   | (31,851 | )
|                              |  |              |         |      |  |   |         |  
|                              |  | $            | 38,093  |      |  | $ | 38,353  |  
|                              |  |              |         |      |  |   |         |  

We entered into a transaction, in which we conveyed our Tempe, Arizona,
facility and certain improvements to the City of Tempe as consideration for a
rent-free 75-year lease. We have the option to repurchase the facility for
$1,000 after ten years; therefore, the lease is accounted for as a capital
lease. The annual lease payments are approximately $100,000, subject to
certain escalation provisions.

We have a high-volume LCD manufacturing line that is depreciated using the
units of production method. During 2001, we elected to move the LCD
manufacturing line from Tempe, Arizona, to Asia. As of December 31, 2001, it
was not in service as it is still in transit to Asia. We believe that the LCD
manufacturing line is stated at its net realizable value at December 31, 2001.

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Other Assets

At December 31, 2001, other assets consist primarily of an investment, at
cost, in a start-up company in the silicon packaging industry. In the second
quarter of 2001, we wrote off a $3.8 million investment in a start-up display
company as we determined the investment was impaired as that term is defined
under generally accepted accounting principles. Subsequent to the second
quarter of 2001, this start-up company ceased operations.

Intangibles

Intangibles consist of licenses and intellectual property related to our
Microdisplay operating segment. Intangibles are recorded at cost and amortized
using the straight-line method over the estimated useful lives of the
respective assets, which range from two to five years. Our policy is to
commence amortization of intangibles when their related benefits are realized.
Amortization for the year ended December 31, 2001 amounted to $749,000.

Accrued Liabilities

Accrued liabilities include, among other things, accrued compensation of
approximately $2,849,000 and $2,000,000 at December 31, 2000 and 2001,
respectively.

Income Taxes

Financial Accounting Standards Board (FASB) Statement of Financial
Accounting Standards (SFAS) No. 109, Accounting for Income Taxes,requires the
use of an asset and liability approach in accounting for income taxes. Deferred
tax assets and liabilities are recorded based on the differences between the
financial statement and tax bases of assets and liabilities and the tax rates
in effect when these differences are expected to reverse.

Foreign Currency Translation

Financial information relating to our foreign subsidiaries is reported in
accordance with SFAS No. 52, Foreign Currency Translation. The functional
currency of Pacific is the same as the local currency. The gain or loss
resulting from the translation of Pacifics financial statements has been
included as a separate component of stockholders equity. Non-U.S. assets and
liabilities are translated into U.S. dollars using the year-end exchange rates.
Revenues and expenses are translated at average rates during the year.

The functional currency of Beijing and Limited is the U.S. dollar.
Beijing, however, maintains its books and records in the Renminbi. Therefore,
we utilize the remeasurement method of foreign currency translation when
Beijing is consolidated. Any resulting remeasurement gain or loss is reported
in our consolidated statements of operations.

The net foreign currency transaction loss in 1999, 2000, and 2001 was
$49,000, $96,000, and $20,000, respectively, and has been included in other
expenses in the accompanying statements of income.

Derivatives

On January 1, 2001, we adopted SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, which establishes accounting and reporting
standards requiring us to recognize derivatives as either assets or liabilities
on the balance sheet and to measure those instruments at fair value. The
adoption of SFAS No. 133 did not have a material impact on our financial
position or results of operation.

We use derivatives to manage exposures to foreign currency fluctuations.
The only type of derivative we use is foreign currency forward contracts. Our
objectives for holding these forward contracts are to decrease the potential
volatility of earnings and cash flows associated with changes in foreign
currency exchange rates (see Note 7). The only risk associated with those
contracts is the cost of purchasing the contract, which we expense at the
expiration of the contract.

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##### Table of Contents



Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists,
delivery has occurred, the fee is fixed or determinable, and collectability is
reasonably assured. Generally, all of these conditions are met at the time we
ship products to customers. We perform ongoing credit evaluations of all of
our customers and consider various factors in establishing our allowance for
doubtful accounts and sales returns and allowances, which amounted to $439,000
and $259,000 at December 31, 2000 and 2001, respectively. Included in net
sales are customer costs associated with shipping and handling.

Research, Development and Engineering

Research, development, and engineering costs are expensed as incurred.

Earnings Per Share

Basic earnings per common share are computed by dividing net income by the
weighted average number of shares of common stock outstanding during the year.
Diluted earnings per common share are determined assuming that outstanding
options and warrants were exercised at the beginning of each year or at the
time of issuance, if later. No outstanding options were assumed to be
exercised for purposes of calculating diluted earnings (loss) per share for the
year ended December 31, 2001, as their effect was anti-dilutive. Set forth
below are the disclosures required pursuant to SFAS No. 128  Earnings Per
Share:

|                                               |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |        |       |  
|---------------------------------------------- | ------------------------------------------------- | ---------------------------------------- | ----- | ------------------------------------- | ---- | ---- | ------ | ------ | ---- | - | ------- | ------ | ----- | -
|                                               |                                                   |                                          |       | Years Ended                          
|                                               |                                                   |                                          |       | December 31,                         
|                                               |                                                   |                                          |       |                                      
|                                               |                                                   |                                          |       | 1999                                  |      | 2000 |        | 2001  
|                                               |                                                   |                                          |       |                                       |      |      |        |       
|                                               |                                                   |                                          |       | (in thousands, except per share data)
|Basic earnings (loss) per share:               |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |       
|                                              
|                                              
|                                              
|                                              
|Income (loss) available to common stockholders |                                                   | $                                        | 6,924 |                                       |      | $    | 14,834 |        |      | $ | (17,764 | )     
|                                               |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |       
|                                               | Weighted average common shares                    |                                          |       | 15,563                                |      |      |        | 20,457 |      |   |         | 21,401 |      
|                                               |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |       
|                                               |                                                   | Basic earnings (loss) per share amount   |       | $                                     | 0.44 |      |        | $      | 0.73 |   |         |        | (0.83 | )
|                                               |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |       
|Diluted earnings (loss) per share:             |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |       
|                                              
|                                              
|                                              
|                                              
|Income (loss) available to common stockholders |                                                   | $                                        | 6,924 |                                       |      | $    | 14,834 |        |      | $ | (17,764 | )     
|                                               |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |       
|                                               | Weighted average common shares                    |                                          |       | 15,563                                |      |      |        | 20,457 |      |   |         | 21,401 |      
|                                              
|                                              
|                                              
|                                              
|                                               | Options and warrants assumed exercised            |                                          |       | 442                                   |      |      |        | 1,179  |      |   |         |       |      
|                                               |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |       
|                                               | Total common shares plus common
stock equivalents |                                          |       | 16,005                                |      |      |        | 21,636 |      |   |         | 21,401 |      
|                                               |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |       
|                                               |                                                   | Diluted earnings (loss) per share amount |       | $                                     | 0.43 |      |        | $      | 0.69 |   |         | $      | (0.83 | )
|                                               |                                                   |                                          |       |                                       |      |      |        |        |      |   |         |       

Recently Issued Accounting Standards

In June 2001, the FASB issued SFAS No. 141, Business Combinations, and
SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires
companies to apply the purchase method of accounting for all business
combinations initiated after June 30, 2001 and prohibits the use of the
pooling-of-interest method. SFAS No. 142 changes the method by which companies
may recognize intangible assets in purchase business combinations and generally
requires identifiable intangible assets to be recognized separately from
goodwill. In addition, it eliminates the amortization of all existing and
newly acquired goodwill on a prospective basis and requires companies to assess
goodwill for impairment, at least annually, based on the fair value of the
reporting unit. We will be required to adopt SFAS Nos. 141 and 142 on January
1, 2002. We have reviewed the requirements of SFAS Nos. 141 and 142 and
believe that the adoption of these statements will not have a material impact
on our financial position or results of operations.

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset
Retirement Obligations. SFAS No. 143 addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. It applies to all entities
and legal obligations associated with the retirement of long-lived assets that
result from the acquisition, construction, development, and/or the normal
operation of the long-lived asset. SFAS No. 143 requires that the fair value
of a liability for an asset retirement obligation be recognized in the period
in which it is incurred if a reasonable estimate of fair value can be made.
The associated asset retirement costs are capitalized as part of the carrying
amount of the long-lived asset and are subsequently allocated to expense

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##### Table of Contents



over the assets useful life. We will be required to adopt SFAS No. 143 on
January 1, 2003. We have reviewed the requirements of SFAS No. 143 and do not
believe that the adoption of this statement will have a material impact on our
financial position or results of operations.

In August 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supersedes SFAS No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of, and the accounting and reporting provisions of APB
Opinion No. 30, Reporting the Results of Operations  Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions. SFAS No. 144 modifies the
method in which companies account for certain asset impairment losses. We will
be required to adopt SFAS No. 144 on January 1, 2002. We have reviewed the
requirements of SFAS No. 144 and do not believe the adoption of this statement
will have a material impact on our financial position or results of operations.

Reclassifications

Certain amounts on the balance sheet as of December 31, 2000 have been
reclassified to conform to the 2001 presentation. These reclassifications have
also been reflected on the statements of cash flows for the years ended
December 31, 1999 and 2000.



|(3) |  | Debt:
|--- |  | -----

Borrowing under line of credit and term loan agreements were as follows at
(in thousands):

|                                                                                                                                                                                                                         |  |              |       |      |  |   |       | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------ | ----- | ---- |  | - | ----- | 
|                                                                                                                                                                                                                         |  | December 31,
|                                                                                                                                                                                                                         |  |             
|                                                                                                                                                                                                                         |  | 2000         |       | 2001
|                                                                                                                                                                                                                         |  |              |       |     
|$15.0 million revolving line of credit, interest
due monthly at the banks prime rate (4.75% at
December 31, 2001) or at the LIBOR base rate
(1.86% at December 31, 2001) plus 1.5%, unpaid
balance due January 31, 2002 |  | $            |      |      |  | $ |      | 
|                                                                                                                                                                                                                        
|                                                                                                                                                                                                                        
|                                                                                                                                                                                                                        
|                                                                                                                                                                                                                        
|$2.706 million loan due Bank of China, interest
due quarterly at 5.85%, due May 8, 2002, secured
by a $3.0 million stand-by letter of credit
issued under the $15.0 million revolving line of
credit                     |  |              | 2,706 |      |  |   | 2,706 | 
|                                                                                                                                                                                                                         |  |              |       |      |  |   |       | 
|                                                                                                                                                                                                                         |  | $            | 2,706 |      |  | $ | 2,706 | 
|                                                                                                                                                                                                                         |  |              |       |      |  |   |       | 

In January 2000, we entered into a $15.0 million unsecured revolving line
of credit with Comerica Bank, which matures on January 31, 2002. This line of
credit bears interest at the lower of the banks prime rate, or at the LIBOR
base rate plus 1.5%, and provides for monthly payments. The revolving line of
credit contains restrictive covenants that include, among other things,
restrictions on the declaration or payment of dividends, the sale or transfer
of assets, and a specified net worth. We have renewed this line of credit
until January 2003.



|(4) |  | Stockholders Equity:
|--- |  | ---------------------

In July 1999, we purchased certain assets and licensed silicon
technologies from National Semiconductor relating to liquid crystal on silicon
(LCoS)microdisplays for approximately $3.0 million in cash and warrants, with
a fair market value of $555,000 as determined by the Black-Scholes option
pricing method, to purchase 140,000 shares of common stock at a price of $8.47
per share, which was the closing price of our companys common stock at the
grant date. We issued 102,014 shares of common stock upon exercise of the
warrants, and the remaining 37,986 shares were used to effect the exercise on
December 20, 2000.

In September 1999, we issued 4,000,226 shares of common stock at $9.69 per
share (the 1999 Offering). The 1999 Offering involved 4,600,000 shares of
common stock consisting of 2,068,686 newly issued shares of our company,
1,931,540 shares issued from treasury, and 599,774 shares sold by an existing
stockholder. In October 1999, we issued 690,000 shares of common stock at
$9.69 per share to cover over-allotments pertaining to the 1999 Offering.
Expenses for the 1999 Offering totaled $3,007,000.

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On November 8, 1999, our Board of Directors approved a four-for-three
stock split, effected in the form of a 33 percent stock dividend. The stock
split was effected on December 17, 1999 to stockholders of record at the close
of business on December 3, 1999. This stock split has been given retroactive
recognition for all periods presented in the accompanying consolidated
financial statements.

On April 18, 2000, our Board of Directors approved a three-for-two stock
split, to be effected in the form of a 50 percent stock dividend. The Boards
approval of the stock split was contingent upon the approval by the
stockholders of an increase in the number of authorized shares of common stock,
which occurred on April 27, 2000. At that time, the stockholders approved an
increase in the number of authorized shares of common stock of our company from
15 million to 60 million. The stock dividend was paid on May 12, 2000 to
stockholders of record at the close of business on May 1, 2000. The stock
split has been given retroactive recognition for all periods presented in the
accompanying consolidated financial statements.

In May 2000, we issued 2,150,000 shares of common stock at $55.00 per
share (the 2000 Offering). In June 2000, we issued 322,500 shares of common
stock at $55.00 per share to cover over-allotments pertaining to the 2000
Offering. Expenses for the 2000 Offering totaled $7,341,000.

On December 7, 2000, our of Directors authorized a stock repurchase
program whereby our company, at the discretion of management, could buy back up
to $30.0 million of our common stock in the open market. During the year ended
December 31, 2000, we purchased 241,381 shares at a cost of $4,623,000. During
the year ended December 31, 2001, we purchased 149,197 shares at a cost of
$2,526,000.

During the second quarter of 2001, our Board of Directors adopted a
stockholder rights plan (the Rights Plan). Under the Rights Plan, we issued
a dividend of one Preferred Share Purchase Right (the Right) for each share
of common stock of our company held by stockholders of record as of the close
of business on May 14, 2001. Each Right entitles stockholders to buy one
one-thousandth (1/1000th) of a share of Series A Junior Participating Preferred
Stock of our company at an exercise price of $120.00 (subject to adjustment).
The Rights Plan was not adopted in response to any specific takeover threat.
The Rights Plan, however, was designed to assure that all of our stockholders
receive fair and equal treatment in the event of any proposed takeover of our
company, and to guard against coercive or unfair tactics to gain control of our
company without paying all stockholders a premium for that control.



|(5) |  | Benefit Plans:
|--- |  | --------------

We have five stock option plans: the 1990 Stock Option Plan (1990 Plan),
the 1993 Stock Option Plan (1993 Plan), the 1994 Non-Employee Directors Stock
Option Plan (1994 Plan), the 1997 Stock Option Plan (1997 Plan), and 1998 Stock
Option Plan (1998 Plan).

1990 Stock Option Plan

Under the 1990 Plan, there were options issued but unexercised to purchase
96,106 shares as of December 31, 2001. The 1990 Plan expired on May 1, 2001,
at which time all unissued options expired.

The expiration date, maximum number of shares purchasable, and the other
provisions of the options granted under the 1990 Plan were established at the
time of grant. Options were granted for terms of up to ten years and became
exercisable in whole or in one or more installments at such times as were
determined by the Board of Directors upon grant of the options.

1993 Stock Option Plan

The 1993 Plan provides for the granting of options to purchase up to
770,909 shares of our common stock, the direct granting of common stock (stock
awards), the granting of stock appreciation rights (SARs), and the granting of
other cash awards (stock awards, SARs, and cash awards are collectively
referred to herein as Awards). Under the 1993 Plan, options and Awards may be
issued to key personnel and others providing valuable services to our company.
The options issued may be incentive stock options or nonqualified stock
options. If any option or SAR terminates or expires without having been
exercised in full, stock not issued under such option or SAR will again be

F-14



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##### Table of Contents



available for grant pursuant to the 1993 Plan. There were options outstanding
to acquire 373,522 shares of our companys common stock under the 1993 Plan at
December 31, 2001.

To the extent that granted options are incentive stock options, the terms
and conditions of those options must be consistent with the qualification
requirement set forth in the Internal Revenue Code of 1986 (the Code). The
expiration date, maximum number of shares purchasable, and the other provisions
of the options will be established at the time of grant. Options may be granted
for terms of up to ten years and become exercisable in whole or in one or more
installments at such time as may be determined by the plan administrator upon
grant of the options. The exercise prices of options are determined by the plan
administrator, but may not be less than 100% (110% if the option is an
incentive stock option granted to a stockholder who at the time the option is
granted owns stock representing more than 10% of the total combined voting
power of all classes of stock of our company) of the fair market value of the
common stock at the time of the grant. The 1993 Plan will remain in force until
February 24, 2003.

1994 Non-Employee Directors Stock Option Plan

The 1994 Plan provides for the automatic grant of stock options to
non-employee directors to purchase up to 100,000 shares of our common stock. On
April 26, 2001, the stockholders approved a proposal to amend our 1994
Automatic Stock Option Plan for Non-Employee Directors (the 1994 Plan). Now,
under the 1994 Plan, options to acquire 2,000 shares of common stock will be
automatically granted to each non-employee director at the meeting of our Board
of Directors held immediately after each annual meeting of stockholders, with
such options to vest in a series of 12 equal and successive monthly
installments commencing one month after the annual automatic grant date. In
addition, each non-employee director serving on our Board of Directors on the
date the 1994 Plan was approved by our stockholders received an automatic grant
of options to acquire 5,000 shares of common stock and each subsequent newly
elected non-employee member of our Board of Directors receives an automatic
grant of options to acquire 5,000 shares of common stock on the date of their
first appointment or election to our Board of Directors. Those options become
exercisable and vest in a series of three equal and successive annual
installments, with the first such installment becoming exercisable immediately
after the directors second successive election to our Board of Directors (the
First Vesting Date), the second installment becoming exercisable 10 months
after the First Vesting Date, and the third installment becoming exercisable 22
months after the First Vesting Date (provided that the director has not ceased
serving as a director prior to a vesting date). A non-employee member of our
Board of Directors is not eligible to receive the 2,000 share automatic option
grant if that option grant date is within 30 days of such non-employee member
receiving the 5,000 share automatic option grant. The exercise price per share
of common stock subject to options granted under the 1994 Plan will be equal to
100% of the fair market value of our common stock on the date such options are
granted. There were outstanding options to acquire 30,260 shares of our common
stock under the 1994 Plan at December 31, 2001.

1997 Stock Option Plan

On January 27, 2000, our Board of Directors increased the number of shares
of our companys common stock available for issuance under the 1997 Plan from
200,000 to 350,000. On August 3, 2000, our Board of Directors increased the
number of shares of our common stock available for issuance under the 1997 Plan
from 350,000 to 650,000.

The 1997 Plan provides for the granting of nonqualified options. Under the
1997 Plan, options may be issued to key personnel and others providing valuable
services to our company. The options issued will be nonqualified stock options
and shall not be incentive stock options as defined in Section 422 of the Code.
Any option that expires or terminates without having been exercised in full
will again be available for grant pursuant to the 1997 Plan. There were options
outstanding to acquire 593,494 shares of our common stock under the 1997 Plan
at December 31, 2001.

The expiration date, maximum number of shares purchasable, and the other
provisions of the options will be established at the time of grant. Options may
be granted for terms of up to ten years and become exercisable in whole or in
one or more installments at such time as may be determined by the plan
administrator upon grant of the options. The exercise prices of the options are
determined by the plan administrator, but may not be less than 100%

F-15



---



##### Table of Contents



of the fair market value of the common stock at the time of the grant. The 1997
Plan will remain in force until May 12, 2007.

1998 Stock Option Plan

During 1999, the stockholders approved an amendment to the 1998 Plan to
increase the number of shares of our common stock that may be issued from
600,000 to 1,100,000.

The 1998 Plan provides for the granting of incentive stock options and/or
nonqualified options. Under the 1998 Plan, options may be issued to key
personnel and others providing valuable services to our company. The options
issued will be incentive stock options or nonqualified stock options as defined
in Section 422 of the Code. Any option that expires or terminates without
having been exercised in full will again be available for grant pursuant to the
1998 Plan. There were options outstanding to acquire 985,239 shares of our
common stock under the 1998 Plan at December 31, 2001.

The expiration date, maximum number of shares purchasable, and the other
provisions of the options will be established at the time of grant. Options may
be granted for terms of up to ten years and become exercisable in whole or in
one or more installments at such time as may be determined by the plan
administrator upon grant of the options. The exercise prices of the options are
determined by the plan administrator, but may not be less than 100% of the fair
market value of the common stock at the time of the grant (110% if the option
is an incentive stock option granted to a stockholder who at the time the
option is granted owns stock representing more than 10% of the total combined
voting power of all classes of stock of our company). The 1998 Plan will remain
in force until January 28, 2008.

Tax benefits from option exercises are credited to additional paid-in
capital.

The following table and narrative summarizes the status of our five stock
option plans at December 31, 1999, 2000, and 2001 and changes during the years
then ended:

|                                               |  |         |           |       |  |          |      |       |  |         |           |          |  |   |       |  |  |          |           |   |  |   |       | 
|---------------------------------------------- |  | ------- | --------- | ----- |  | -------- | ---- | ----- |  | ------- | --------- | -------- |  | - | ----- |  |  | -------- | --------- | - |  | - | ----- | 
|                                               |  | 1999    |           | 2000  |  | 2001    
|                                               |  |         |           |       |  |         
|                                               |  |         |           |       |  | Weighted |      |       |  |         |           | Weighted |  |   |       |  |  | Weighted
|                                               |  |         |           |       |  | Average  |      |       |  |         |           | Average  |  |   |       |  |  | Average 
|                                               |  |         |           |       |  | Exercise |      |       |  |         |           | Exercise |  |   |       |  |  | Exercise
|                                               |  | Options |           | Price |  | Options  |      | Price |  | Options |           | Price   
|                                               |  |         |           |       |  |          |      |       |  |         |           |         
|Outstanding at beginning
of year               |  |         | 1,399,750 |       |  | $        | 6.10 |       |  |         | 1,737,397 |          |  | $ | 7.76  |  |  |          | 1,974,668 |   |  | $ | 14.75 | 
|                                              
|                                              
|                                              
|                                              
|Granted                                        |  |         | 1,021,957 |       |  |          | 8.51 |       |  |         | 528,873   |          |  |   | 33.95 |  |  |          | 534,995   |   |  |   | 19.44 | 
|                                              
|                                              
|                                              
|                                              
|Exercised                                      |  |         | (157,475  | )     |  |          | 1.94 |       |  |         | (228,063  | )        |  |   | 7.46  |  |  |          | (235,665  | ) |  |   | 6.55  | 
|                                              
|                                              
|                                              
|                                              
|Expired or canceled                            |  |         | (526,835  | )     |  |          | 6.56 |       |  |         | (63,539   | )        |  |   | 9.58  |  |  |          | (195,377  | ) |  |   | 36.20 | 
|                                               |  |         |           |       |  |          |      |       |  |         |           |          |  |   |       |  |  |          |           |   |  |   |       | 
|Outstanding at end of year                     |  |         | 1,737,397 |       |  |          | 7.76 |       |  |         | 1,974,668 |          |  |   | 14.75 |  |  |          | 2,078,621 |   |  |   | 14.87 | 
|                                               |  |         |           |       |  |          |      |       |  |         |           |          |  |   |       |  |  |          |           |   |  |   |       | 
|Exercisable at end of year                     |  |         | 447,707   |       |  | $        | 6.73 |       |  |         | 485,050   |          |  | $ | 7.12  |  |  |          | 618,236   |   |  | $ | 9.81  | 
|                                               |  |         |           |       |  |          |      |       |  |         |           |          |  |   |       |  |  |          |           |   |  |   |       | 
|Weighted average fair value of
options granted |  |         |           |       |  | $        | 6.54 |       |  |         |           |          |  | $ | 27.24 |  |  |          |           |   |  | $ | 15.76 | 
|                                               |  |         |           |       |  |          |      |       |  |         |           |          |  |   |       |  |  |          |           |   |  |   |       | 

The following table summarizes information about stock options outstanding
at December 31, 2001:

|                    |              |                     |             |             |          |          |          |              |             |          |          |      |  |  |         |         |  |   |       |      | 
|------------------- | ------------ | ------------------- | ----------- | ----------- | -------- | -------- | -------- | ------------ | ----------- | -------- | -------- | ---- |  |  | ------- | ------- |  | - | ----- | ---- | 
|Options Outstanding |              | Options Exercisable
|                    |              |                    
|                    |              |                     | Number      |             | Weighted |          |          |              |             |          | Number   |      |  |  |        
|                    |              |                     | Outstanding |             | Average  |          | Weighted |              | Exercisable |          | Weighted
|Range of            |              | at                  |             | Remaining   |          | Average  |          | at           |             | Average 
|Exercise            |              | December 31,        |             | Contractual |          | Exercise |          | December 31, |             | Exercise
|Prices              |              | 2001                |             | Life        |          | Price    |          | 2001         |             | Price   
|                    |              |                     |             |             |          |          |          |              |             |         
|$0.32 - $7.46       |              |                     | 479,506     |             |          |          | 6.3      |              |             | $        | 5.81     |      |  |  | 296,698 |         |  | $ | 5.63  |     
|                   
|                   
|                   
|                   
|                    | 7.47  14.92 |                     |             | 707,716     |          |          |          | 7.4          |             |          |          | 9.39 |  |  |         | 253,127 |  |   |       | 9.29 | 
|                   
|                   
|                   
|                   
|14.93  74.63       |              |                     | 891,399     |             |          |          | 8.8      |              |             |          | 24.09    |      |  |  | 68,411  |         |  |   | 29.88 |     
|                    |              |                     |             |             |          |          |          |              |             |          |          |      |  |  |         |         |  |   |       |     
|                    |              |                     | 2,078,621   |             |          |          | 7.8      |              |             | $        | 14.87    |      |  |  | 618,236 |         |  | $ | 9.81  |     
|                    |              |                     |             |             |          |          |          |              |             |          |          |      |  |  |         |         |  |   |       |     

F-16



---



##### Table of Contents



Pursuant to the provisions of SFAS No. 123, Accounting for Stock-Based
Compensation, we account for transactions with our employees pursuant to
Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued
to Employees, under which no compensation cost has been recognized. However, we
have computed, for pro forma disclosure purposes, the value of all options
granted during 1999, 2000, and 2001, using the Black-Scholes option pricing
method with the following weighted assumptions: risk-free interest rates of
6.34%, 4.75%, and 4.42%; expected dividend yields of zero; expected lives of
6.2, 6.2, and 6.1 years; and expected volatility (a measure of the amount by
which a price has fluctuated or is expected to fluctuate during a period) of
61.9%, 72.6%, and 74.5%, respectively. Had compensation cost for these plans
been determined consistent with SFAS No. 123, our net income and earnings per
share would have been as follows:

|                                   |             |  |                          |       |      |  |      |        |  |  |   |         |  
|---------------------------------- | ----------- |  | ------------------------ | ----- | ---- |  | ---- | ------ |  |  | - | ------- | -
|                                   |             |  | Years Ended December 31,
|                                   |             |  |                         
|                                   |             |  | 1999                     |       | 2000 |  | 2001
|                                   |             |  |                          |       |      |  |     
|                                   |             |  | (in thousands,          
|                                   |             |  | Except per share data)  
|Net income (loss):                 |             |  |                          |       |      |  |      |        |  |  |   |        
|                                  
|                                  
|                                  
|                                  
|                                   | As reported |  | $                        | 6,924 |      |  | $    | 14,834 |  |  | $ | (17,764 | )
|                                  
|                                  
|                                  
|                                  
|                                   | Pro forma   |  |                          | 5,423 |      |  |      | 13,000 |  |  |   | (20,987 | )
|                                  
|                                  
|                                  
|                                  
|Basic earnings (loss) per share:   |             |  |                          |       |      |  |      |        |  |  |   |        
|                                  
|                                  
|                                  
|                                  
|                                   | As reported |  | $                        | 0.44  |      |  | $    | 0.73   |  |  | $ | (0.83   | )
|                                  
|                                  
|                                  
|                                  
|                                   | Pro forma   |  |                          | 0.35  |      |  |      | 0.64   |  |  |   | (0.98   | )
|                                  
|                                  
|                                  
|                                  
|Diluted earnings (loss) per share: |             |  |                          |       |      |  |      |        |  |  |   |        
|                                  
|                                  
|                                  
|                                  
|                                   | As reported |  | $                        | 0.43  |      |  | $    | 0.69   |  |  | $ | (0.83   | )
|                                  
|                                  
|                                  
|                                  
|                                   | Pro forma   |  |                          | 0.34  |      |  |      | 0.60   |  |  |   | (0.98   | )

401(k) Profit Sharing Plan

We have adopted a profit sharing plan (401(k) Plan) pursuant to Section
401(k) of the Code. The 401(k) Plan covers substantially all full-time
employees who meet the eligibility requirements and provides for a
discretionary profit sharing contribution by us and an employee elective
contribution with a discretionary matching provision by our company. We
expensed discretionary contributions pursuant to the 401(k) Plan in the amount
of $159,000, $207,000, and $262,000 for the years ended December 31, 1999,
2000, and 2001, respectively.

Pension Plan

On June 1, 2001, Pacific adopted a defined benefit pension plan (the
Pension Plan), covering most regular Pacific employees. As of December 31,
2001, no funding of the plan had occurred. Net periodic pension cost of $95,000
was recorded during the year ended December 31, 2001. In addition, at December
31, 2001, the projected benefit obligation of $349,000 is included in accrued
liabilities.



|(6) |  | Income Taxes:
|--- |  | -------------

The provision (benefit) for income taxes for the years ended December 31
consists of the following (in thousands):

F-17



---



##### Table of Contents



|                                                          |                                                         |                            |       |       |       |      |       |       |       |  |        |        |        |  
|--------------------------------------------------------- | ------------------------------------------------------- | -------------------------- | ----- | ----- | ----- | ---- | ----- | ----- | ----- |  | ------ | ------ | ------ | -
|                                                          |                                                         |                            |       | 1999  |       | 2000 |       | 2001 
|                                                          |                                                         |                            |       |       |       |      |       |      
|Current provision (benefit), net of tax credits utilized: |                                                         |                            |       |       |       |      |       |       |       |  |        |       
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Federal, net of tax benefit from stock option
exercises |                            | $     | 2,619 |       |      | $     | 4,641 |       |  | $      | (5,555 | )     
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | States                                                  |                            |       | 210   |       |      |       | 45    |       |  |        |       |       
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Foreign                                                 |                            |       | 832   |       |      |       | 780   |       |  |        | 797    |       
|                                                          |                                                         |                            |       |       |       |      |       |       |       |  |        |       
|                                                          |                                                         |                            | 3,661 |       |       |      | 5,466 |       |       |  | (4,758 | )     
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Deferred benefit                                        |                            |       | (723  | )     |      |       | (626  | )     |  |        | (4,575 | )     
|                                                         
|                                                         
|                                                         
|                                                         
|                                                          | Tax benefit from stock option exercises                 |                            |       | 30    |       |      |       | 674   |       |  |        | 588    |       
|                                                          |                                                         |                            |       |       |       |      |       |       |       |  |        |       
|                                                          |                                                         | Provision for income taxes |       | $     | 2,968 |      |       | $     | 5,514 |  |        | $      | (8,745 | )
|                                                          |                                                         |                            |       |       |       |      |       |       |       |  |        |        |       

In accordance with SFAS No. 109, tax credits of approximately $115,000,
$1,244,000, and $0 were utilized in 1999, 2000, and 2001, respectively, and are
included as a reduction of the current provision for income taxes in the
consolidated statements of income.

The components of deferred taxes at December 31 are as follows (in
thousands):

|                                                 |                                                           |   |        |        |      |   |       |        |  
|------------------------------------------------ | --------------------------------------------------------- | - | ------ | ------ | ---- | - | ----- | ------ | -
|                                                 |                                                           |   | 2000   |        | 2001
|                                                 |                                                           |   |        |        |     
|Net short-term deferred tax assets:              |                                                           |   |        |        |      |   |       |       
|                                                
|                                                
|                                                
|                                                
|                                                 | Uniform capitalization                                    |   | $      | 1,071  |      |   | $     | 1,224  |  
|                                                
|                                                
|                                                
|                                                
|                                                 | Accrued liabilities and reserves not currently deductible |   |        | 3,102  |      |   |       | 2,405  |  
|                                                
|                                                
|                                                
|                                                
|                                                 | Allowance for doubtful accounts                           |   |        | 150    |      |   |       | 76     |  
|                                                
|                                                
|                                                
|                                                
|                                                 | Other                                                     |   |        | 23     |      |   |       | 225    |  
|                                                 |                                                           |   |        |        |      |   |       |        |  
|                                                 |                                                           | $ | 4,346  |        |      | $ | 3,930 |       
|                                                 |                                                           |   |        |        |      |   |       |        |  
|Net long-term deferred tax (liabilities)/assets: |                                                           |   |        |        |      |   |       |       
|                                                
|                                                
|                                                
|                                                
|                                                 | Accelerated tax depreciation                              |   | $      | (4,110 | )    |   | $     | (4,556 | )
|                                                
|                                                
|                                                
|                                                
|                                                 | Net operating loss and tax credit carryforward            |   |        |       |      |   |       | 5,153  |  
|                                                
|                                                
|                                                
|                                                
|                                                 | Capital loss carryforward                                 |   |        |       |      |   |       | 1,299  |  
|                                                
|                                                
|                                                
|                                                
|                                                 | Valuation allowance against capital loss carryforward     |   |        |       |      |   |       | (1,299 | )
|                                                
|                                                
|                                                
|                                                
|                                                 | Investments in foreign affiliates                         |   |        | (377   | )    |   |       | (378   | )
|                                                 |                                                           |   |        |        |      |   |       |       
|                                                 |                                                           | $ | (4,487 | )      |      | $ | 219   |       
|                                                 |                                                           |   |        |        |      |   |       |        |  

A reconciliation of the U.S. federal statutory rate to our effective tax
rate is as follows:

|                                            |  |      |    |      |  |      |    |   |  |  |     |   
|------------------------------------------- |  | ---- | -- | ---- |  | ---- | -- | - |  |  | --- | --
|                                            |  | 1999 |    | 2000 |  | 2001
|                                            |  |      |    |      |  |     
|Statutory federal rate                      |  |      | 34 | %    |  |      | 35 | % |  |  | (34 | %)
|                                           
|                                           
|                                           
|                                           
|Effect of state taxes                       |  |      | 3  |      |  |      | 2  |   |  |  |    |   
|                                           
|                                           
|                                           
|                                           
|Foreign earnings taxed at different rates   |  |      | (4 | )    |  |      | (5 | ) |  |  | (3  | ) 
|                                           
|                                           
|                                           
|                                           
|Other, net                                  |  |      | 3  |      |  |      |   |   |  |  | 1   |   
|                                           
|                                           
|                                           
|                                           
|Valuation Allowance                         |  |      |   |      |  |      |   |   |  |  | 5   |   
|                                           
|                                           
|                                           
|                                           
|Benefit from prior year state refund claims |  |      | (6 | )    |  |      |   |   |  |  |    |   
|                                           
|                                           
|                                           
|                                           
|Credits for research and experiment         |  |      |   |      |  |      | (5 | ) |  |  | (2  | ) 
|                                            |  |      |    |      |  |      |    |   |  |  |     |   
|                                            |  |      | 30 | %    |  |      | 27 | % |  |  | (33 | )%
|                                            |  |      |    |      |  |      |    |   |  |  |     |   

A deferred U.S. tax liability has not been provided on the undistributed
earnings of certain foreign subsidiaries because it is our intent to
permanently reinvest such earnings. Undistributed earnings of foreign
subsidiaries, which have been, or are intended to be, permanently invested in
accordance with APB No. 23, Accounting for Income Taxes  Special Areas,
aggregated approximately $4,288,000 and $4,901,325 at December 31, 2000 and
2001, respectively.

Although losses are expected to continue in the near term, as of December
31, 2001, in accordance with SFAS No. 109, no valuation allowance has been
recorded related to our net operating loss and tax credit carryforward, as we
believe that the full realization of these deferred tax assets is more likely
than not.

F-18



---



##### Table of Contents





|(7) |  | Commitments and Contingencies:
|--- |  | ------------------------------

Rent and Lease

In April 2001, Pacific began its lease of a build-to-suit factory in
Manila. The term of the lease is 125 months. We employ our own employees at
this new factory. Pacific still employs a third-party subcontractor in Manila
at our original factory site to provide some direct labor services. The
third-party subcontractor operates a facility utilizing equipment, processes,
and documentation owned by us.

Our future lease commitments under the non-cancelable operating leases as
of December 31, 2001 are as follows (in thousands):

|           |  |   |        | 
|---------- |  | - | ------ | 
|2002       |  | $ | 1,125  | 
|          
|          
|          
|          
|2003       |  |   | 921    | 
|          
|          
|          
|          
|2004       |  |   | 1,048  | 
|          
|          
|          
|          
|2005       |  |   | 1,040  | 
|          
|          
|          
|          
|Thereafter |  |   | 11,776 | 
|           |  |   |        | 
|           |  | $ | 15,910 | 
|           |  |   |        | 

Rent expense was approximately $763,000, $553,000, and $712,000 for the
years ended December 31, 1999, 2000, and 2001, respectively.

Guarantee

We have guaranteed up to $500,000 of the debt of a start-up company,
VoiceView Technology, Inc., a private company developing microdisplay products.
We will be required to pay this guarantee to the lender if the start-up
company defaults on its debt obligations.

Legal Proceedings

We are involved in certain administrative proceedings arising in the
normal course of business. In our opinion, the ultimate settlement of these
administrative proceedings will not materially impact our financial position or
results of operations.

Derivative Instruments

We have certain receivables denominated in Chinese Renminbi. To eliminate
our exposure to changes in the U.S. dollar/Chinese Renminbi exchange rate, we
have entered into forward contracts to protect our future cash flows. Our
forward contracts generally range from one to six months in original maturity.
In accordance SFAS No. 133, we designate such forward contracts as cash flow
hedges. We account for changes in the fair value of our forward contracts,
based on changes in the forward exchange rate, with all such changes in fair
value reported in other comprehensive income. Amounts in other comprehensive
income are reclassified into earnings upon settlement of the forward contract
at an amount that will offset the related transaction gain or loss arising from
the re-measurement and adjust earnings for the cost of the forward contracts.
During 2001, there were no significant gains or losses recognized in earnings
for hedge ineffectiveness. As of December 31, 2001, there were four forward
contracts outstanding with a cumulative notional value of $4.0 million,
expiring through April 2002. Also, we did not discontinue any hedges because
it was probable that the original forecasted transaction would not occur.



|(8) |  | Segment Information:
|--- |  | --------------------

We monitor and evaluate the financial performance of our operations by our
two product lines (operating segments): direct view display and microdisplay.
The direct view display operating segment consists of products that employ an
LCD (Liquid Crystal Display) to present information to the user. The
microdisplay operating segment consists of products that employ a Liquid
Crystal on Silicon (LCoS) display to present information to the user. The
accounting policies of the operating segments are the same as those described
in Note 2, Summary of Significant Accounting Policies. Non-specific operating
segment expenses were allocated based upon estimated

F-19



---



##### Table of Contents



usage. Interest income was all assigned to the direct view display
operating segment. The worldwide average tax rate was used for all segments.
The following includes financial information (in thousands, except share data)
for our two operating segments:

|                                           |  |             |         |              |  |       |        |   |  |   |         |  
|------------------------------------------ |  | ----------- | ------- | ------------ |  | ----- | ------ | - |  | - | ------- | -
|                                           |  | Direct View |         |              |  |       |        |   |  |  
|                                           |  | Display     |         | Microdisplay |  | Total
|                                           |  |             |         |              |  |      
|December 31, 1999                          |  |             |         |              |  |       |        |   |  |   |         |  
|                                          
|                                          
|                                          
|                                          
|Net sales                                  |  | $           | 147,210 |              |  | $     | 198    |   |  | $ | 147,408 |  
|                                          
|                                          
|                                          
|                                          
|Other expenses                             |  |             | (18     | )            |  |       |       |   |  |   | (18     | )
|                                          
|                                          
|                                          
|                                          
|Provisions for (benefit from)
income taxes |  |             | 4,903   |              |  |       | (1,935 | ) |  |   | 2,968   |  
|                                          
|                                          
|                                          
|                                          
|Net income (loss)                          |  |             | 11,440  |              |  |       | (4,516 | ) |  |   | 6,924   |  
|                                          
|                                          
|                                          
|                                          
|Earnings (loss) per share                  |  |             | 0.71    |              |  |       | (0.28  | ) |  |   | 0.43    |  

|                                          |  |             |         |              |  |       |        |   |  |   |         | 
|----------------------------------------- |  | ----------- | ------- | ------------ |  | ----- | ------ | - |  | - | ------- | 
|                                          |  | Direct View |         |              |  |       |        |   |  |  
|                                          |  | Display     |         | Microdisplay |  | Total
|                                          |  |             |         |              |  |      
|December 31, 2000                         |  |             |         |              |  |       |        |   |  |   |         | 
|                                         
|                                         
|                                         
|                                         
|Net sales                                 |  | $           | 159,369 |              |  | $     | 1,315  |   |  | $ | 160,684 | 
|                                         
|                                         
|                                         
|                                         
|Other income                              |  |             | 7,184   |              |  |       |       |   |  |   | 7,184   | 
|                                         
|                                         
|                                         
|                                         
|Provision for (benefit from)
income taxes |  |             | 7,770   |              |  |       | (2,256 | ) |  |   | 5,514   | 
|                                         
|                                         
|                                         
|                                         
|Net income (loss)                         |  |             | 20,904  |              |  |       | (6,070 | ) |  |   | 14,834  | 
|                                         
|                                         
|                                         
|                                         
|Earnings (loss) per share                 |  |             | 0.97    |              |  |       | (0.28  | ) |  |   | 0.69    | 

|                          |  |             |         |              |  |       |         |   |  |   |         |  
|------------------------- |  | ----------- | ------- | ------------ |  | ----- | ------- | - |  | - | ------- | -
|                          |  | Direct View |         |              |  |       |         |   |  |  
|                          |  | Display     |         | Microdisplay |  | Total
|                          |  |             |         |              |  |      
|December 31, 2000         |  |             |         |              |  |       |         |   |  |   |         |  
|                         
|                         
|                         
|                         
|Net sales                 |  | $           | 117,234 |              |  | $     | 1,902   |   |  | $ | 119,136 |  
|                         
|                         
|                         
|                         
|Other
income (expense)    |  |             | 7,270   |              |  |       | (3,820  | ) |  |   | 3,450   |  
|                         
|                         
|                         
|                         
|Benefit
from income taxes |  |             | (1,832  | )            |  |       | (6,913  | ) |  |   | (8,745  | )
|                         
|                         
|                         
|                         
|Net Loss                  |  |             | (3,732  | )            |  |       | (14,032 | ) |  |   | (17,764 | )
|                         
|                         
|                         
|                         
|Loss per share            |  |             | (0.17   | )            |  |       | (0.66   | ) |  |   | (0.83   | )

On January 1, 2000, we also began tracking net sales and long-lived assets
data by geographic location. Net sales by geographic area are determined based
upon the location of the end customer while long-lived assets are based upon
the physical location of our companys assets. The following includes
financial information (in thousands) for our geographic areas:

|                         |  |         |        |       |  |         |        |       |  |   |        |  |  |   |         | 
|------------------------ |  | ------- | ------ | ----- |  | ------- | ------ | ----- |  | - | ------ |  |  | - | ------- | 
|                         |  | North   |        |       |  |         |        | Other |  |   |        | 
|                         |  | America |        | China |  | Foreign |        | Total
|                         |  |         |        |       |  |         |        |      
|December 31, 2000        |  |         |        |       |  |         |        |       |  |   |        |  |  |   |         | 
|                        
|                        
|                        
|                        
|Net Sales                |  | $       | 25,414 |       |  | $       | 61,835 |       |  | $ | 73,435 |  |  | $ | 160,684 | 
|                        
|                        
|                        
|                        
|Long-lived assets, gross |  |         | 40,869 |       |  |         | 11,453 |       |  |   | 17,866 |  |  |   | 70,188  | 

|                         |  |         |        |       |  |         |        |       |  |   |        |  |  |   |         | 
|------------------------ |  | ------- | ------ | ----- |  | ------- | ------ | ----- |  | - | ------ |  |  | - | ------- | 
|                         |  | North   |        |       |  |         |        | Other |  |   |        | 
|                         |  | America |        | China |  | Foreign |        | Total
|                         |  |         |        |       |  |         |        |      
|December 31, 2001        |  |         |        |       |  |         |        |       |  |   |        |  |  |   |         | 
|                        
|                        
|                        
|                        
|Net Sales                |  | $       | 20,026 |       |  | $       | 48,310 |       |  | $ | 50,800 |  |  | $ | 119,136 | 
|                        
|                        
|                        
|                        
|Long-lived assets, gross |  |         | 45,707 |       |  |         | 12,739 |       |  |   | 18,393 |  |  |   | 76,839  | 

F-20



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##### Table of Contents





|(9) |  | Selected Quarterly Financial Data (Unaudited)
|--- |  | ---------------------------------------------

The following table summarizes the unaudited consolidated quarterly
results of operations as reported for 2000 and 2001 (in thousands, except per
share amounts):

|                                  |         |   |                |      |         |   |         |      |         |   |         |      |         |   |         |      |         |   |        |      |  |   |         |       |   |   |        |       |   |   |        |       |  
|--------------------------------- | ------- | - | -------------- | ---- | ------- | - | ------- | ---- | ------- | - | ------- | ---- | ------- | - | ------- | ---- | ------- | - | ------ | ---- |  | - | ------- | ----- | - | - | ------ | ----- | - | - | ------ | ----- | -
|                                  |         |   | Quarters Ended
|                                  |         |   |               
|                                  |         |   | 2000           |      | 2001   
|                                  |         |   |                |      |        
|                                  |         |   | Mar. 31        |      | June 30 |   | Sep. 30 |      | Dec. 31 |   | Mar. 31 |      | June 30 |   | Sep. 30 |      | Dec. 31
|                                  |         |   |                |      |         |   |         |      |         |   |         |      |         |   |         |      |        
|Net sales                         |         | $ | 39,162         |      |         | $ | 44,926  |      |         | $ | 40,231  |      |         | $ | 36,365  |      |         | $ | 35,616 |      |  | $ | 25,013  |       |   | $ | 26,594 |       |   | $ | 31,913 |      
|                                 
|                                 
|                                 
|                                 
|Gross profit (loss)               |         |   | 9,802          |      |         |   | 10,769  |      |         |   | 9,116   |      |         |   | 6,273   |      |         |   | 4,373  |      |  |   | (7,147  | )     |   |   | (859   | )     |   |   | 1,255  |      
|                                 
|                                 
|                                 
|                                 
|Net income (loss)                 |         |   | 3,587          |      |         |   | 4,369   |      |         |   | 4,345   |      |         |   | 2,533   |      |         |   | 242    |      |  |   | (11,348 | )     |   |   | (3,996 | )     |   |   | (2,662 | )    
|                                 
|                                 
|                                 
|                                 
|Earnings (loss) per
Common share: |         |   |                |      |         |   |         |      |         |   |         |      |         |   |         |      |         |   |        |      |  |   |         |       |   |   |        |       |   |   |        |      
|                                 
|                                 
|                                 
|                                 
|                                  | Basic   |   | $              | 0.19 |         |   | $       | 0.22 |         |   | $       | 0.20 |         |   | $       | 0.12 |         |   | $      | 0.01 |  |   | $       | (0.53 | ) |   | $      | (0.19 | ) |   | $      | (0.12 | )
|                                 
|                                 
|                                 
|                                 
|                                  | Diluted |   |                | 0.18 |         |   |         | 0.21 |         |   |         | 0.19 |         |   |         | 0.11 |         |   |        | 0.01 |  |   |         | (0.53 | ) |   |        | (0.19 | ) |   |        | (0.12 | )



|(10) |  | Events Subsequent to the Date of the Auditors Report (Unaudited)
|---- |  | -----------------------------------------------------------------

In January 2002, we purchased certain intellectual property as well as
certain assets from an emerging display company for approximately $2.6 million.

In 1991, we received a notice of potential liability at the
Barkhamsted-New Hartford Landfill Site (the Landfill) in Barkhamsted,
Connecticut from the United States Environmental Protection Agency (EPA).
Fifty-seven other entities received similar letters. In January 1992, we
received a 104(e) questionnaire from the EPA which was completed and submitted
during 1992. We received verbal notification that we had no further liability
in the matter. According to the EPA, groundwater contamination at the site,
which includes volatile and semi-volatile organic compounds and low
concentrations of metals, constitutes a low-level threat. As a result of
previous actions at the site, groundwater is the only medium requiring
additional cleanup. All source material and principal threats have been
addressed through the landfill capping and related activity completed in 1999.
On February 28, 2002, we received notification from the EPA that the EPA
believes we are an involved party and indicated that the EPA was seeking to
negotiate an agreement with the involved parties to fund the EPAs chosen
remedy of monitored natural attenuation of the groundwater. The EPA indicated
that further notification would be made in the next 60 days, which notification
will include the names of any other involved parties. We are evaluating our
potential liability at the site. The Landfill is a semi-active waste disposal
area consisting of 97.84 acres located in Barkhamsted and New Hartford,
Connecticut. The Landfill is owned and operated by the Administrative Board of
Regional Refuse Disposal and began operating as a landfill in 1974. Industrial
wastes were received by the Landfill until 1993, and the Landfill was closed in
1995. The EPA has conducted a Remedial Investigation/Feasibility Study and
issued a Proposed Plan to clean up the site.

F-21



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##### Table of Contents



THREE-FIVE SYSTEMS, INC. AND SUBSIDIARIES

SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
For the Years Ended December 31, 1999, 2000 and 2001

|                                                                  |                       |  |                     |     |                  |  |                  |      |            |  |        |   |                   |  |   |    |  |  |   |     | 
|----------------------------------------------------------------- | --------------------- |  | ------------------- | --- | ---------------- |  | ---------------- | ---- | ---------- |  | ------ | - | ----------------- |  | - | -- |  |  | - | --- | 
|                                                                  |                       |  |                     |     |                  |  | Increases        |      |            |  |        |   |                   |  |   |    |  |  |  
|                                                                  |                       |  |                     |     |                  |  | (Reductions)     |      |            |  |        |   |                   |  |   |    |  |  |  
|                                                                  |                       |  | Balance at          |     | Charged to Costs |  | Charged to Other |      |            |  |        |   | Balance at End of
|                                                                  |                       |  | beginning of Period |     | and Expenses     |  | Accounts         |      | Write-offs |  | Period
|                                                                  |                       |  |                     |     |                  |  |                  |      |            |  |       
|                                                                  |                       |  | (in thousands)     
|Allowance for doubtful accounts and sales
returns and allowances: |                       |  |                     |     |                  |  |                  |      |            |  |        |   |                   |  |   |    |  |  |   |    
|                                                                 
|                                                                 
|                                                                 
|                                                                 
|                                                                  | Year ended 12/31/1999 |  | $                   | 516 |                  |  | $                | 219  |            |  | $      |  |                   |  | $ | 15 |  |  | $ | 750 | 
|                                                                 
|                                                                 
|                                                                 
|                                                                 
|                                                                  | Year ended 12/31/2000 |  | $                   | 750 |                  |  | $                | (316 | )          |  | $      |  |                   |  | $ | 5  |  |  | $ | 439 | 
|                                                                 
|                                                                 
|                                                                 
|                                                                 
|                                                                  | Year ended 12/31/2001 |  | $                   | 439 |                  |  | $                | (180 | )          |  | $      |  |                   |  | $ |   |  |  | $ | 259 | 

S-1



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##### Table of Contents



Exhibit Index

|               |  |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Exhibits                                                                                                                                                                                                                                                                                                                                                                                                                                   
|               |  |                                                                                                                                                                                                                                                                                                                                                                                                                                            
|2              |  | Amended and Restated Agreement and Plan of Reorganization(1)                                                                                                                                                                                                                                                                                                                                                                               
|              
|              
|              
|              
|3(a)           |  | Amended and Restated Certificate of Incorporation of the Company(2)                                                                                                                                                                                                                                                                                                                                                                        
|              
|              
|              
|              
|3(b)           |  | Certificate of Amendment of Restated Certificate of Incorporation(3)                                                                                                                                                                                                                                                                                                                                                                       
|              
|              
|              
|              
|3(c)           |  | Amended and Restated Bylaws of the Company(4)                                                                                                                                                                                                                                                                                                                                                                                              
|              
|              
|              
|              
|4              |  | Form of Certificate of Common Stock(4)                                                                                                                                                                                                                                                                                                                                                                                                     
|              
|              
|              
|              
|4(b)           |  | Rights Agreement, dated as of April 26, 2001, between Three-Five Systems, Inc. and Bank of
New York, as Rights Agent, together with the following exhibits thereof: Exhibit A  Form
of Certificate of Designation of Series A Junior Participating Preferred Stock of
Three-Five Systems, Inc.; Exhibit B  Form of Right Certificate; Exhibit C  Summary of
Rights to Purchase Shares of Preferred Stock of three-Five Systems, Inc. (5)
|              
|              
|              
|              
|10(a)          |  | Amended and Restated 1997 Employee Option Plan (as amended through February 2001)(6)                                                                                                                                                                                                                                                                                                                                                       
|              
|              
|              
|              
|10(c)          |  | Line of Credit Agreement between Three-Five Systems Limited and Barclays Bank, PLC(1)                                                                                                                                                                                                                                                                                                                                                      
|              
|              
|              
|              
|10(g)          |  | Form of Three-Five Systems, Inc. Distributor Franchise Agreement(7)                                                                                                                                                                                                                                                                                                                                                                        
|              
|              
|              
|              
|10(j)          |  | 1993 Stock Option Plan(7)                                                                                                                                                                                                                                                                                                                                                                                                                  
|              
|              
|              
|              
|10(k)          |  | 1994 Automatic Stock Option Plan(8)                                                                                                                                                                                                                                                                                                                                                                                                        
|              
|              
|              
|              
|10(o)          |  | Lease dated April 1, 1994, between Papago Park Center, Inc. and Three-Five Systems, Inc.(9)                                                                                                                                                                                                                                                                                                                                                
|              
|              
|              
|              
|10(v)          |  | 1997 Employee Stock Option Agreement(10)                                                                                                                                                                                                                                                                                                                                                                                                   
|              
|              
|              
|              
|10(w)          |  | Amended and Restated Three-Five Systems, Inc. 1998 Stock Option Plan, amended as of
January 28, 1999, as approved by the Companys stockholders on April 22, 1999(11)                                                                                                                                                                                                                                                                      
|              
|              
|              
|              
|10(x)          |  | Amended and Restated 1994 Stock Option Plan for the Non-Employee Directors(12)                                                                                                                                                                                                                                                                                                                                                             
|              
|              
|              
|              
|10(z)          |  | 401(k) Profit Sharing Plan(13)                                                                                                                                                                                                                                                                                                                                                                                                             
|              
|              
|              
|              
|10(aa)         |  | Credit Agreement dated January 21, 2000, by and among Three-Five Systems, Inc., its
subsidiaries, the Banks named therein, and Imperial Bank Arizona, as Agent and as Issuing
Bank(12)                                                                                                                                                                                                                                                     
|              
|              
|              
|              
|10(cc)         |  | Modification Agreement dated February 1, 2001, by and among Three-Five Systems, Inc., its
subsidiaries, the Banks named in the Credit Agreement, and Imperial Bank as administrative
agent and as Issuing Bank(14)                                                                                                                                                                                                                         
|              
|              
|              
|              
|21             |  | List of Subsidiaries(4)                                                                                                                                                                                                                                                                                                                                                                                                                    
|              
|              
|              
|              
|23             |  | Consent of Arthur Andersen LLP*                                                                                                                                                                                                                                                                                                                                                                                                            



---

|*    |  | Filed herein.                                                                                                                                                                                                                                                                   
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    
|    
|    
|    
|(1)  |  | Incorporated by reference to the Registration Statement on Form S-4 of TF
Consolidation, Inc. (Registration No. 33-33944) as filed March 27, 1990
and declared effective March 27, 1990.                                                                                        
|    
|    
|    
|    
|(2)  |  | Incorporated by reference to the Registrants Form 10-QSB for the quarter
ended March 31, 1994, as filed with the Commission on or about May 12,
1994.                                                                                                                          
|    
|    
|    
|    
|(3)  |  | Incorporated by reference to the Registrants Form S-3/A as filed with
the Commission on May 5, 2000.                                                                                                                                                                           
|    
|    
|    
|    
|(4)  |  | Incorporated by reference to the Registration Statement on Form S-3
(Registration No. 333-84083) as filed on July 30, 1999, as amended by Form
S-3/A filed on August 26, 1999, and declared effective September 27, 1999.                                                       
|    
|    
|    
|    
|(5)  |  | Incorporate by reference to the Registrants Form 8-A as filed with the
Commission on May 10, 2001.                                                                                                                                                                             
|    
|    
|    
|    
|(6)  |  | Incorporated by reference to the Registrants Form S-8 as filed with the
Commission on November 3, 2000.                                                                                                                                                                        
|    
|    
|    
|    
|(7)  |  | Incorporated by reference to the Registration Statement on Form S-1
(Registration No. 33-74788) as filed on February 3, 1994, and declared
effective March 15, 1994.                                                                                                            
|    
|    
|    
|    
|(8)  |  | Incorporated by reference to the Registration Statement on Form S-8
(Registration No. 33-88706) as filed on January 24, 1995.                                                                                                                                                   
|    
|    
|    
|    
|(9)  |  | Incorporated by reference to the Registrants Form 10-K for the fiscal
year ended December 31, 1996, as filed with the Commission on March 14,
1997.                                                                                                                            
|    
|    
|    
|    
|(10) |  | Incorporated by reference to the Registrants Form 10-K for the fiscal
year ended December 31, 1997, as filed with the Commission on March 13,
1998, and as amended by Form 10-K/A filed with the Commission on March 23,
1998.                                                 
|    
|    
|    
|    
|(11) |  | Incorporated by reference to the Registration Statement on Form S-8
(Registration No. 333-87875) as filed on September 27, 1999.                                                                                                                                                
|    
|    
|    
|    
|(12) |  | Incorporated by reference to the Registrants Form 10-Q for the quarter
ended June 30, 2001, as filed with the Commission on July 27, 2001.                                                                                                                                     
|    
|    
|    
|    
|(13) |  | Incorporated by reference to the Registration Statement on Form S-8
(Registration No. 333-57933) as filed on June 26, 1998.
Incorporated by reference to the Registrants Form 10-K for the fiscal year
ended December 31, 2000, as filed with the Commission on March 13, 2001.
|    
|    
|    
|    
|(14) |  | Incorporated by reference to the Registrants Form 10-K for the fiscal year ended December 31, 2000, as filed with the Commission on March 13, 2001.                                                                                                                            

S-2